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Hedging Against the Decline of the Blue Social Model

January 23, 2013 | About:
Blogger and Bard College professor Walter Russell Meade has written for years about the decline of what he calls the Blue Social Model, the post-World War II economic structure built on unionized middle class jobs with generous wages in government at oligarchical private sector firms such as the old AT&T. Of course, those sorts of private sector middle class jobs have been disappearing for decades, so what Meade has focused on is the unsustainability of unionized public sector jobs, with the increasingly parlous finances of state and local governments. Professor Meade noted in a post last week that the New York Times now acknowledges the fragility of this model.

In that post, Meade quotes Thomas Edsall of the New York Times:
Dozens of city and state public employee pension plans are on the verge of bankruptcy—or are actually bankrupt—from Rhode Island to California; in 2010, a survey of 126 state and local plans showed assets of $2.7 trillion and liabilities of $3.5 trillion, an $800 billion shortfall.
Meade concludes: "The reality of blue model decline is so obvious that nobody can ignore it any longer."

Hedging a Few Securities That Could Be Impacted by Blue Model Decline

With the decline of the blue social model gaining wider currency, I thought it would be interesting to look at the cost of hedging a few securities that could be affected by this. The three that came to mind were the iShares S&P National AMT-Free Muni Bond fund ETF (MUB), the PowerShares Insured National Muni Bond fund ETF (PZA), and the municipal bond insurer Assured Guarantee Ltd. (AGO). First we'll look at the optimal puts* for hedging MUB and PZA against greater-than-10% declines over the next several months.

The Optimal Puts to Hedge MUB and PZA

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The screen capture above shows the optimal puts, as of Tuesday's close, to hedge MUB and PZA against greater-than-10% drops over the next several months. That the uninsured municipal bond ETF, MUB, is so much cheaper to hedge, on a percentage basis, than the insured municipal bond ETF PZA is an interesting result. Curious to see if PZA was levered, I took a quick glance at its prospectus, but didn't see a mention of leverage there. It is less diversified than MUB, though, with nearly 30% of its assets in its top 10 holdings, versus MUB, which has about 3% of its assets in its top 10.

Not Good Candidates for Hedging with Optimal Collars

In our last post, we wrote about how investors willing to cap their potential upsides can, in some cases, reduce or eliminate their hedging costs by using optimal collars**. PZA isn't one of those cases. Even if you enter 1% as your cap when using Portfolio Armor, you won't find an optimal collar for PZA now, due to a paucity of out-of-the-money calls with bids. You'll find an optimal collar for MUB with a 1% cap, but since I can't imagine why anyone would use a cap that small, without getting paid to do so (if you think the ETF only has 1% upside, why not just sell it?), I haven't included it here.

Hedging AGO with Optimal Puts

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The screen capture above shows the optimal puts, as of Tuesday's close, to hedge 1000 shares of AGO against a greater-than-20% drop over the next several months. I've used a 20% threshold on this one for a couple of reasons: because equity investors are generally less risk-averse than bond investors and so might be willing to tolerate a larger percentage drawdown, and because there are no optimal puts for AGO using a 10% threshold—the cost of hedging AGO against a greater-than-10% drop is itself greater than 10%. Unlike MUB and PZA, though, there is an optimal collar available for AGO using a reasonable cap.

Hedging AGO with an Optimal Collar

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The screen capture above shows the optimal collar, as of Tuesday's close, to hedge 100 shares of AGO against a greater-than-20% drop over the next several months, if you are willing to cap your potential upside at 10% over the same time frame. Like the two optimal collars in our previous post, this is a negative cost collar: because the income from the call leg is greater than the cost of the put leg, an investor opening this collar is getting paid to hedge.

The Mystery of MUB

If, as Walter Russell Meade suggests in the post we quoted above, the decline of the Blue Social Model is widely acknowledged, why is it so inexpensive to hedge a fund invested in the debt obligations of blue states? Do options market participants expect that blue states would rather raise taxes and cut services than stiff municipal bond investors? Or do they expect that ultimately the federal government will continue to keep the states above water fiscally? And if so, what impact will that have on federal debt (since the federal government, of course, has to borrow to send money to the states)? We'll take a look at hedging securities invested in federal debt in a future post.

*Optimal puts are the ones that will give you the level of protection you want at the lowest possible cost. Portfolio Armor (available on the web and as an Apple iOS app), uses an algorithm developed by a finance Ph.D. to sort through and analyze all of the available puts for your stocks and ETFs, scanning for the optimal ones.

**Optimal collars are the ones that will give you the level of protection you want at the lowest net cost, while not limiting your potential upside by more than you specify. The extension to the Portfolio Armor algorithm to find optimal collars was developed by a post-doctoral fellow in the financial engineering department at Princeton University. This capability is currently available on the web version of Portfolio Armor, and will be available soon as an in-app subscription for the iOS app.

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