The Barbell Portfolio

HTM bonds for predictability, LEAPS calls for optionality

Never stay in the middle of the curve. The majority seeks the path with the least resistance – the comfort of the crowd.

The outcome is “more of the same.” More of the same thoughts, decisions, actions, and results.

Being with a crowd is not only about quantity. It is about quality. Staying in the middle suggests being mediocre. Mediocrity and excellence do not exist in one sentence. In investing, too.

Then what to do? Become obsessed with questioning everything, but mainly yourself.

In investing, this means taking the path less traveled. To expand horizons, investigate arcane industries, unpopular markets, and overlooked tools.

TheOldEconomy is my cabinet of curiosities, and today’s article is no exception. Instead of another shipping nano cap or obscure EM idea, it's time to go beyond equity.

Let’s talk about bonds, options, and weightlifting.

Time, probability, and payoffs

What is the relation between time and probability?

Think about bonds and options. The first thing to notice is that they have a predefined lifespan. Thus, they are explicitly time-dependent. Options’ life is determined by expiration, while bonds’ is by maturity.

Knowing the lifespan helps to estimate the probability distribution. For bonds, this is the default probability; for options, it is the odds option ending ITM (in the money).

What about the risk-reward? Bonds usually have a risk-reward below 0.5, while long calls offer a risk-reward above 3.

Bonds and options represent two sides of The Barbell. On the left side, we have an asset with a low default probability and low-risk reward; on the other side, we have an asset with a high default probability and a high-risk reward. The first category describes bonds and, to a certain degree, preferred equity. The second category describes long call options.

The Barbell strategy is a powerful approach to constructing a portfolio that exploits time, volatility, and probability.

Let’s talk about each side of the barbell.

A note: I cover HTM (held-to-maturity) bonds, and LEAPS calls here. The concepts and heuristics discussed below do not always apply to other strategies with fixed-income instruments and derivatives.

Bonds

At first glance, bonds are more complex than equity and offer mediocre yields. This is true to some degree. Between 2010 and 2022, US government bonds were return-free assets. Since the rate hikes, they have become a reasonable proposition. Nevertheless, they are far from lucrative.

Corporate bonds offer appealing compensation for the risk taken and the opportunity cost. We get better yields at reasonable risk.

The curve describing the risk as a function of yield is convex, not linear. So, the higher the yield, the higher the risk is true, but to some degree. The point is that the default probability growth is not proportional to yield growth.

How do we measure default probability? This parameter is estimated against bond duration and the risk of issuer default, which is reflected in the bond issuer’s credit rating.

For example, a bond with a BBB+ credit rating and a 5-year duration. What is the default probability?

The table shows a default probability of 0.85%, which means that roughly one out of 100 bonds will fail.

To clarify, this number shows the frequency, not the distribution. In a sample of 100 BBB+ bonds, we may have five defaults or a 5% rate. Zero defaults are also a plausible scenario.

Both cases do not suggest that the S&P chart is wrong. They remind us about the relationship between sample size and estimate deviation. The larger the sample pool, the lower the deviation, and vice versa.

One crucial aspect of credit rating agencies is credibility (pun intended). The ESG/DEI agenda has taken a heavy toll. Below is a quote from my Beyond Equity report for October:

Let’s elaborate more on default rates. YPF and BW Energy have lower default rates based on their liquidity and solvency figures, not solely on their credit ratings. YPF has a CCC rating (S&P), which suggests a 46.91% probability of default in five years. Over the last several years, credit ratings have transformed from risk-measuring tools into ESG/DEI scoreboards. Companies in emerging markets are perceived as not so ESG/DEI aspiring, so they get lower ratings despite their financials.

The level of wokeness undermines the quality of the conclusions. This is another reason why to question the company’s credit rating. At best, use it as a reference point. Never skip DIY because the S&P, Moody’s, and Fitch will do your job.

A politically incorrect hack: the longer the ESG/DEI section of corporate documents, the more questionable the credit rating is.

Bonds offer RR<0.5, while equity and options offer asymmetry in investors’ favor. Let’s give an example.

Assume we have a bond (B- credit rating) with a 9% coupon rate that trades at $90 (a 10% discount from the bond’s par value of $100). The bond matures after 12 months, and the payments come annually. For 12 months, we realized 21.1% (10% yield plus 11.1% capital gains). RR in the example above is 0.23. It looks like a suboptimal bet.

Now, consider the default probability. Based on bond credit ratings, the chances of losing the principal are single digits, in this case, 5.89%. With bonds, we pay with asymmetric payoffs to obtain predictability and mitigate the risk.

Options

Options are another misunderstood instrument. They gained popularity recently because of 0DTE. But zero-day options are weapons for mass account decimation. Yet they are promoted as philosopher’s stone, turning every position into gold.

We have to look elsewhere. Options’ strength resides in their time and volatility dependency. A meticulously executed option strategy is a true wealth builder, making it perfectly suitable for the barbell strategy.

What options have in common with bonds is their explicit time dependency. Hence, the option’s probability distribution could be calculated in advance. In that case, we estimate the chance of an option ending in money.

Let’s look at the first derivative of the underlying asset price, delta. The table below shows the YPF call option with an expiration date of January 2027.

I chose the option with a $50 strike price. This contract comes with a $0.533 delta. So, for every $1 change in YPF’s share price, the option price will increase by $0.533. The delta also indicates the probability of the option ending ITM during the option’s life.

Options theory assumes that market returns follow a normal distribution. Black and Scholes’s formula for valuing options is built around that presumption. That said, we must take delta estimates with a grain of salt. 

Apply delta as a reference. For instance, we have an option with 0.4 delta. This means the probability of the option ending ITM is 40%. Instead of a fixed number, use a range. Assume the estimated delta is the best-case scenario, i.e., the upper border of probability distribution. So, in that case, we have a 20-40% chance of being right.

By using options, we profit from:

• Rising underlying price

• Rising volatility

Plus, we are immune to path dependency by owning a long call option. The price we pay is time dependency. There are no solutions, only trade-offs.

In summary, options provide an asymmetric payoff with a high probability of default.

Bonds and options remind us of the importance of time. They have a predefined lifespan, so estimating their probability distribution is less difficult. To emphasize, it is not precise and guaranteed. The option’s fail rate may exceed 50%, while the bond default probability is below 10%.

Knowing the probability is half of the equation. The second part is the payoff. Options bring RR>5, while bonds RR<0.5. Considered in isolation, fixed income is far from appealing. The same applies if accounting only for the default probability; options appear unfeasible.

Combining probability and risk-reward, we obtain two categories of assets defined by distinct odds and payoff. None of them is superior to the other. Each serves a specific function that the other can’t. Blended, they create The Barbell.

The Barbell

On the left side, we have low default probability assets with inversed asymmetry. Such assets are fixed-income securities and preferred equity. This is the Low side.

On the right other side, we have high default probability assets with favorable asymmetry, such as long-call options. This is the High side.

There is no fixed proportion between the sides, although the left side must be more than 70% to benefit from the strategy. The optimal solution is 80-90% for the Low side and 10-20% for the High side.

Of course, for large books where principal preservation and income are priorities at the expense of growth, the Low side may go up to 100%. In that situation, the bond’s income could be used to purchase LEAPS calls.

Besides the weight of bonds vs. options, the lifespan of assets must be considered. Divide the Low side into five segments, each representing a year. Think like a bank. In our case, bank loans are corporate bonds we own. The bank will never give loans with the same maturity.

A critical aspect is the size of an individual position. Bonds have inversed asymmetry. Low RR implies that we need many winners to recoup a loss. Here comes the role of LEAPS calls.

They have RR often higher than five. If we bet 1% of our book on XYZ call with RR 1:5 and eventually win, we get a 5% return on assets (on the entire portfolio). Assume that the average option winner brings 5-7% ROA. So, allocate 5-7% per bond issuer. If the company defaults, we lose 5 - 7 % of our book. However, we can quickly recover the loss with only one LEAPS winner.

In summary, apply diversified concentration for the High side and diversified diversification for the Low side. As you can see, it’s all about risk management. Finding the best bonds and options is far from enough without an execution plan on a macro and micro level.

In Practice

The Barbell is the new perk for Pro subscribers. It perfectly complements the quarterly reports and beyond equity ideas.

Here is how it is looking The Barbell:

The portfolio size is $100,000. It follows the 80/20 distribution: 80% bonds and preferred equity, and 20% options. The Low side is fully invested. The High side capital is not fully allocated.

The top section shows the portfolio’s performance. I estimate ROA for the entire book per segment: High Side ROA, and Low Side ROA. Then, I measure the total ROA. The middle table shows Low side assets (bonds and preferred stocks). It includes basic metrics like coupon, current price, yield, and YTM. The bottom table shows the options side with basic parameters, such as entry price, stop loss, take profit, and RR.

The Barbell strategy is for an industrious investor who likes to take predefined risks without sacrificing optionality. HTM bonds deliver risk mitigation and predictability, while LEAPS calls asymmetry and optionality.

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On the markets, we are wrong until proven otherwise. So, take the above thoughts with a grain of salt.

Everything described in this report has been created for educational purposes only. It does not constitute advice, recommendation, or counsel for investing in securities.

The opinions expressed in such publications are those of the author and are subject to change without notice. You are advised to do your own research and discuss your investments with financial advisers to understand whether any investment suits your needs and goals.