July 6, 2010
The annualized returns from selling covered calls are substantial. The longer-dated options are preferable, of course, but the longest date for an option varies between stocks.
With 10% of the portfolio in each of these nine stocks, we can add an annualized 3.6% to the income from the high-yield portfolio by selling call options against its holdings. Added to the dividend yield of 6.1%, this brings the total annual income from the portfolio to 9.7% per year.
Selling the covered calls raises the income from the portfolio, and while it does not affect its downside volatility, it does limit upside potential. By selling covered calls, we have a total yield of 9.7% with expected volatility of 21%. To put this in context, selling covered calls gives a yield that is more than 2.5 times what long-term government bonds can offer, but with almost identical risk.
Another way to look at these results is that the covered-call high-yield strategy provides 0.8% less in yield than the high-yield corporate bond ETF COY, but with much lower volatility (21% annualized volatility vs. 36%). One might argue that the strategy of selling covered calls is unlike a long position in either COY or TLT because we have sold off most of the potential for price appreciation. The yields on both TLT and COY are so high relative to their expected returns, however, that there is not much upside potential left in these ETFs.
One of the very useful features of ETFs for income investors is that many have options on them. In a recent article, I discussed buying puts on a long-term bond ETF, TLT. Investors who want to compare income strategies like those outlined here, but with ETFs instead of individual stocks, might consider buying a dividend-oriented ETF, such as the iShares Select Dividend Index (DVY), and selling call options against it. As of this writing, the longest-dated options on DVY expire rather soon, in December 2010, meaning that the investor would have to sell additional options in six months. DVY has a yield of 3.9% with implied volatility of about 23%. Selling a covered call with a December 2010 expiration can add another 3.1% in income between now and the end of the year. On an annualized basis, selling the covered call brings the total yield up to a bit more than 10%. The Utilities Select SPDR, XLU, has options with expiration dates out to January 2012 with implied volatility of about 23%. Selling slightly out-of-the-money January 2012 call options against XLU brings the combined yield of the ETF plus option premium up to 7.1%.
Conclusions
We have explored income investing by analyzing yield vs. risk, along with the sensitivity of each investment alternative to changes in interest rates. In the current environment, long-term government bonds are unattractive because of their high sensitivity to interest rates, their low yields, and their high risk. Investment-grade corporate bonds are more attractive, with lower risk, higher yield, and lower sensitivity to interest rates. High-yield corporate bonds have very high yields and positive correlation to interest rates, but they are risky (depending, of course, on the credit characteristics of the bonds).
A portfolio made up mainly of high-yield stocks is quite attractive. My example here has a 6.1% yield with 21% volatility and a near-zero correlation to long-term rates. This portfolio is comparable on a risk-adjusted basis to one that is 40% COY and 60% TLT, which also has a yield of 6.1% but with expected volatility of 13.4%. This portfolio also has a modest positive correlation to long-term rates.
In the current environment, the best solution is to sell covered calls against the stocks in the model high-yield portfolio. This portfolio provides 9.7% in income with 21% in expected volatility. No combination of bond ETFs can provide this level of income with comparable risk, meaning that income investors who aren’t looking to go for broke will be hard-pressed to find a more optimal portfolio.
Comparing yield to expected volatility as a way to analyze income portfolios makes a great deal of sense. Further, to the extent that we only want to compare individual stocks or ETFs, all we have to know is the implied volatility from options and the current yield. To analyze portfolios and mutual funds, we need to take the next step by using Monte Carlo simulations to account for the correlations between holdings in a portfolio, and thereby come up with a consistent estimate of total expected volatility.
The ultimate income portfolio will be quite attractive if the “New Normal” worldview espoused by PIMCO, with its forecast of higher interest rates and stunted economic growth, should come to pass. In such an environment, dividends will likely make up a larger fraction of total returns from equities, and selling off the potential for capital appreciation via call options is likely to be a smart choice.
Geoff Considine is the author of a new book, Survival Guide for a Post-Pension World, as well as a book on the use of options strategies in wealth management. More information is available at www.quantext.com.
Geoff’s firm, Quantext is a strategic adviser to FOLIOfn,Inc. (www.foliofn.com), an innovative brokerage firm specializing in offering and trading portfolios for advisors and individual investors.
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