Protection from the downside
Over the year to 30 June 2002, the average earnings per share from the companies comprising the S&P 500 Index was around $27bn (E26bn). Interestingly, approximately 25% ($6.5) of this was accounted for by pensions income contributions ie, credits. This situation emerged because of the healthy funded position within these companies’ pension plans together with optimistic actuarial assumptions. But what a difference a year makes. IBM (US), for example, is about to contribute over $4bn to shore up its pension plan’s finances.
Therefore going forward, it looks like we can expect a significant percentage of the S&P 500 earnings to vanish as a result of three inter-related negative factors: significant erosion of the value of pension plans’ investment portfolios; write-down of the existing pension assets/credits on corporate US’s balance sheets; and pension credits turning into pension expenses
For companies with under funded plans, any write-down in shareholder equity can put the company in a situation of failing to comply with its debt covenants and forcing negotiations with its lenders. According to the Wall Street Journal, GM’s estimated $23bn shortfall in its US plan (up from $9.1bn in 2001) was a factor in S&P’s decision to cut GM’s debt rating to two levels above non-investment grade.
Recent experience has shown us that the worst-case scenario for any pension plan is an environment where falling equity markets combine with falling long-term interest rates. Over the past 24 months we have seen major equity markets fall by around 35% while long duration AA-rated bond yields have fallen from around 7% to 6%.
So how have some companies addressed this risk and avoided the extreme repercussions of the recent bear markets? In principle, they have used variations on simple option-based hedging strategies designed to help protect against equity downside risk, of which there are four possible variations:
1. The straightforward protective put
2. The put-spread
3. The zero cost collar; and
4. The zero cost put-spread collar
When considering which strategy to employ sponsors need to take into account a number of factors. In particular, they should consider the following:
1. What level of downside protection is required?
2. If the underlying index rises, how much underperformance would the fund be willing to bear
3. How long should the hedge be put in place.
Other factors such as levels of implied volatility will also have a bearing on the relative attractiveness of each of these strategies
The protective put
This is the most straightforward strategy to employ. Which strike price is chosen very much depends on the risk aversion of the sponsor ie, how much downside risk to take. A six month put, which foregoes the first 5% of downside protection (a 95% put) would currently cost approximately 6.5%. This is historically a relatively high cost and is a reflection of the high-implied volatility in option prices and the current instability of equity markets. The ideal outcome for such a strategy would be either be a strong rise in the market that more than covers the cost of the option or a fall that is sufficient to make the cost of the option worthwhile. Where it is not ideal is if the market falls but remains just above the put strike price – in this instance the investor will have both lost money from a falling market as well as having had to pay the option premium without receiving any protection.
The following strategies can help to reduce the cost of a put at the expense of either foregoing some protection or foregoing most of the potential upside as markets rise.
The put-spread involves buying a put that is close to being at-the-money (ATM) but also selling a put option that is further out-of-the-money (OTM).
Thus, for example, a 95%-75% put spread means that the portfolio will be protected once it has fallen by 5% and will continue to be protected thereafter as long as the market does not decline by more than 25% ie, fall through the 75% strike. However, should the index fall through the 75% strike the portfolio would still outperform the market by the difference between the strikes of 20% (95%-75%) less the premium paid.
Two characteristics of options increase the attractiveness of this strategy: the positive relationship between implied volatility and price; and the existence of volatility skew. The skew, holding everything else constant, results in implied volatility rising the further OTM the option is. This strategy involves the fund buying and selling puts at different strike levels but with all other factors constant (time horizon, interest rates, dividends and execution level). Therefore, the fund would receive a proportionately higher price for the OTM put sale compared to the ATM put purchase.
A 6-month 95%-75% put spread would cost around 4.6%, which is almost 2% cheaper than the straightforward put. The downside here is that the portfolio has foregone protection below 75% of the current market level.
Again, the ideal outcome is similar to the protective put. The slight difference here is that because a lower premium has been paid for the put-spread, this strategy will require less of a sharp move to give a positive or negative return.
Collar and zero-cost collar
A second way of reducing the cost of paying for protection is to sell an OTM call. When the purchase of a put option is combined with the sale of call option, the strategy is known as a collar. This type of strategy caps the upside through the sale of the call but gives full protection from the level of the strike price on the put. The cost of a collar will depend on the strike price of the put and the strike price of the call. However, should investors want a specified level of downside protection eg, buying a 95% put, then it is possible to find a call with a certain strike price that can be sold such that the proceeds from the call sale finance completely the purchase of the put. This type of trade is known as a zero-cost collar.
A six month 95% put, for example, can be financed by selling a call that is approximately 4.25% out-of-the-money (a 104.25% call). In this case the investor could, for zero cost, protect his downside exposure below 95% of the current index level at the expense of capping any gains should the market rise by more than 4.25%. The performance between the long put strike and the short call strike is identical to the performance a straight investor would receive.
Although this strategy may seem attractive due to the minimal or non-existent outlay, there would be a serious performance disadvantage if the market was to move through the call strike level and continue rising above this level. It thus requires the investor to have a strongly negative view of the market over the time horizon of the option or to be comfortable with capping any gains above a certain level. A more attractive strategy may be the zero-cost put-spread collar.
Zero-cost put-spread collar
Here, the put-spread discussed earlier is wholly financed by the sale of a call. In the example above of the six-month zero-premium collar the upside is limited to around 4.25%. By undertaking a zero-premium put-spread collar, however, we can increase the upside potential by a further, say 4.35% to 8.60%. The additional upside potential has been made possible by virtue of reducing the level of downside protection. In this case the portfolio is protected between 75% and 95% of the current market level.
In conclusion, it is likely that we will see a significant reduction in the earnings per share from a number of the larger constituents of the S&P 500 over the coming months as a result of the double squeeze of higher pension expenses coupled with the reversal of existing pension credits from corporate balance sheets. To an extent this could have been mitigated somewhat through the protection of the capital value of the plan’s equity portfolios. While the argument often offered against the use of a protection strategy is one of cost (particularly given the currently high implied volatility currently being priced into option prices), there are a number of ways to implement such strategies, namely:
1. Those that offer full downside protection and unlimited upside potential. Only straight puts offer this but this strategy is the costliest
2. Those offering protection for zero cost. These encompass zero-cost collars and zero-cost put-spread collars. Here upside potential and downside protection is determined by the desire for zero premium outlay
3. Those that offer greater upside potential at the expense of reduced protection. This would include both collars and put-spreads with put-spreads being the cheaper of the two strategies but with less downside protection.
* Prices used in the article are indicative and not real time.
Mike O’Brien is managing director and Per Tingberg senior derivatives portfolio manager at Barclays Global Investors in London