Income in a Zero-Rate World

One look at the yields on US Treasuries tells a good part of the story. Listening to Fed Chief Ben Bernanke gives us the rest: it is going to be very hard making any kind of money in many traditional fixed income instruments using the conventional method of clipping bond coupons. Certificates of Deposit won’t be much better moving forward. It would seem as though we are destined for either zero or near zero short-term interest rates for at least the next year.

At the same time, equity markets have been atrocious. That goes without saying. And it hasn’t just been the US markets either. International indexes have been decimated. Commodities, save Gold, have been hammered as well. There are always FOREX markets, trading options, and futures, but they are risky and often outside the comfort zone of the average investor. So the big question right now is how does one aspire to make any money in the markets given the current realities? Fortunately, there are a couple of strategies that are relatively easy to implement for the average investor. We’ll outline two of them here.

The Hedged Dividend Portfolio Model

The first idea is to create a situation where the investor is able to secure a higher rate of dividend income than that of traditional fixed income investments while significantly decreasing the risk to the portfolio. In order to do this, a portfolio of dividend paying assets is selected, and an appropriate hedge is identified to protect the investment. This allows the investor to get a comparatively high dividend yield while providing a higher degree of capital preservation than would otherwise be possible. The problem with hedges is that markets don’t always go down, nor do they always go up. Obviously, when markets are moving higher a hedge will be a boat anchor on any portfolio. Conversely, the absence of a hedge in a falling market will also be a boat anchor. The challenge is identifying the bigger moves and acting accordingly. Back in December, we took a look at some model portfolios that were based on the investment themes focused on by the financial media during 2008. Of the three, let’s focus in on the energy portfolio, simply because it paid the best dividends of the three mentioned in that article:

Security	Symbol	5/19/2008 Price	11/20/2008 Price
Penn West Energy Trust	PWE	$33.83	$12.42
PenGrowth Energy Trust	PGH	$20.84	$7.84
Baytex Energy Trust	BTE	$29.20	$12.09
Harvest Energy Trust	HTE	$25.52	$9.20
Schlumberger	SLB	$106.63	$40.02
Permian Basin Royalty Trust	PBT	$24.74	$16.27
Kinder Morgan	KMP	$60.22	$45.37
Buckeye Partners	BPT	$49.11	$27.77
Ultrashort Oil&Gas ETF	DUG	$26.69	$49.57

This model contains 4 Canadian Royalty Trusts, an oil service company, two Master Limited Partnerships (MLP’s), and an express Trust. The model is heavy on the side of Canadian Royalty Trusts because they have been a popular vehicle for individuals to invest in oil and natural gas.

This model portfolio paid $19.98/share in dividends during the course of the period studied. The assumption for the portfolio is that an equal number of shares were purchased for each issue listed. Let’s say for example that we purchased a round lot (100 shares) of each and a 16% hedge (250 shares) of DUG.

The initial cost of our portfolio on 5/19/08 (recent market high) would have been $41,681.50 plus any applicable commissions. The November 11/20/08 value (recent market low) was $29,490.50 for a loss of $12,191.00 or 29.25%. The dividends paid during that time would have totaled $1,998.00, a yield of 4.79% for just 6 months. Considering the S&P 500 lost 47.25% during the same period, the hedged strategy performed much better and produced dividends at an annual rate of 9.58% as well.

Obviously, if the price of oil and natural gas had continued to rise, this would not have been an appropriate move since we would likely have gotten capital appreciation in addition to the dividends but the hedge would have lost significant value. The obvious risk to this type of an approach is that the incorrect hedge is used or a major market signal is missed. The whipsaw of the energy markets underscores the need to be up on the wheel in terms of keeping up with this type of a strategy. While it can certainly pay off, like anything else, it requires constant vigilance. The benefits are obviously the dividends and the knowledge that even if you don’t nail every move; you are still getting paid handsomely to wait until market conditions become favorable. And in the case of energy, you have the conviction of the belief that you are investing in a wasting asset that is becoming more and more difficult to get to market.

Income Through Covered calls

A second method that investors can use to make money on investments they hold is by writing covered calls. It isn’t as complicated as it sounds. In the interests of brevity, I will present a short primer of how an option works, focusing on calls for the purposes of this article.

A call gives the holder the right to purchase 100 shares of a stock at a given price, or ‘strike price’ for a period of time. For this option, the purchaser pays a premium. Let’s use an example to illustrate. Joe buys a call for Company XYZ at a strike price of $30 that expires in 3 months. The current share price is $28. Joe is speculating that the price of the stock will go up within the next 3 months. If indeed that happens, he can either sell his option to someone else (if it appreciates in value) or, if the price of the shares goes above $30, he can exercise his option, purchase the shares at $30 then sell them on the market for a profit. However, if the share price doesn’t move or goes down, Joe’s option will expire worthless.

Now let’s flip the roles and look at it from the standpoint of the investor who holds the shares. Let’s say that Joe buys 500 shares of XYZ stock at $28/share. What he can do is sell 5 calls (each call is an option on 100 shares) at a strike price of say $35. For selling these options, he’ll receive the premium, which will vary on a number of items such as the volume of options at that date and strike price, the time involved, and other factors.

Joe’s calls are ‘covered’ because he already owns the shares. If the option is exercised, he’ll just surrender his own shares as opposed to having to go out in the market and purchase them (naked call).

In the ‘worst’ case, the stock price rises to the point where the option holder will exercise and Joe will have to sell his $500 shares at $35/share. However, he not only received the premium from selling the options, but he also made $7/share. So his profit is $3,500 plus whatever he made selling the options. If the stock stays under $35, the option will expire unexercised and Joe can sell 5 more covered calls and bring in more premium.

For stocks that are stuck in a range, this is a great strategy. Applying this strategy to a dividend-paying portfolio is a great way to enhance income, especially in a down market such as what we are dealing with right now. By combining this tactic with the hedged portfolio presented in the previous example, a fairly stable basket of dividend producing assets with extra income from the covered calls can be created.

Some things to consider

• It is a good idea to sell calls at a strike price that is significantly above what was paid for the shares. The example above is a reasonable one. If the strike price is too close to the current market price, you stand a better chance of getting blown out of your position. You’ll likely bring in more in premium for those options, but the likelihood of losing your position must be weighed. This is especially true if the intent is to collect dividends and supplement the dividend income with covered calls.
• Tax implications must also be considered. Generally for IRA type accounts this is not an issue as all taxes are deferred anyway. However, in the case of an individual taxable account, Joe’s $2,500 gain would be taxed as a capital gain. The amount of time Joe held his shares would determine whether he’d pay the short or long term rate.
• Writing uncovered or naked calls is not generally advisable and is typically more risky because the writer of the naked call has to have the money available to purchase the shares to sell should the option be exercised. For an investor who is looking to augment dividend income, writing naked calls is probably not a great idea.

If there is one silver lining to the current zero-rate environment, it is that consumer prices have not gone ballistic at the same time. The reduction in energy costs have helped consumers immensely and slightly lessened the need for inflation fighting 10-15% returns (see table below).

Observed Inflation Rate	Tax Bracket	Return required to break even
5%	28%	6.94%
7%	28%	7.92%
10%	28%	13.89%

However, by seeking out these types of returns anyway, investors can begin to either recoup some of what they lost in 2008 or prepare for a future that is at best unclear. Based on recent money supply figures, the assumption that we will once again be entering a period of high inflation is a pretty good one.

Perhaps the most important take-home message from this article is that when you buy a stock you become an equity owner in that firm. And it is my belief that equity owners should share in the profits of the firm rather than resting their success solely on the hope that someone will come along at some point in the future and give them more for their shares than they paid.

It must be noted that these strategies are not suitable for every investor. The model portfolio in this article is used for informative and illustrative purposes only and should not be taken as an investment recommendation or offer to buy or sell any security. Always consult a qualified financial professional before making any investment decisions.

Comments

[Chris B:]

Risk-free profits! Right this way ladies and gentlemen! What could go wrong?

Feb 02 08:56 AM

[Steve in TN:]

Why not consider corporate bonds? LQD, the blue chip corporate bond ETF is paying over 5% currently.

Feb 02 09:21 AM

[morph366:]

In relation to your first strategy of holding high dividend stocks and then hedging against the stock prices falling I think you underestimate the task of protecting yourself. You say "The problem with hedges is that markets don’t always go down, nor do they always go up " which is unquestionably true. The real problem however is calibrating the appropriate cross-correlations and beta values etc between your long holdings and whatever your hedge instrument is. One can measure the correlations, beta values etc from historical observations but there is nothing necessarily predictive about those values. Even the best conceived hedge ratios and strategies can go awry so I would be a little less confident about the free lunches.

Feb 02 09:33 AM

[svosavvy:]

Don't forget that if you sell a call and then chicken out in a rising market you can always buy them back for a premium and then not lose your coveted position. It is hard to covet any equity right now.

Feb 02 09:52 AM

[Sajo:]

Article topic aside, I believe Andy chose the incorrect ticker symbol (BPT) for Buckeye Partners within the table of the Energy Portfolio. The correct symbol ought to be BPL if my assumption is correct.

Pls correct it, Andy, lest some readers be led astray with trading actions. Thanks.

Feb 02 09:55 AM

[biomedlives:]

The problem I have with covered calls is that the potential upside (when the stock goes up and the call holder exercises) is almost always less than the downside (when the stock declines substantially.) I prefer following the old maxim of letting profits run and cutting losses short.

Feb 02 10:52 AM

[a believer:]

Re your second strategy:

"In the ‘worst’ case, the stock price rises to the point where the option holder will exercise and Joe will have to sell his $500 shares at $35/share."

No, no, NO.

"In the ‘worst’ case, the stock price falls to the point where it is worth pennies on the dollar, and, not having developed an exit strategy that allows you to consistently make money using covered calls, you lose most of your initial investment."

Feb 02 10:53 AM

[henarl:]

svosavvy: Of course you are correct that you can always buy back your covered call prior to the exercise date if the underlying stock appreciates beyond the call price. Depending on how far above strike price the stock has appreciated, you can also sell a new call, further out in time and at a higher strike price, for possibly more than the cost of buying back the original call. This is called rolling up and out.
Andy: Sajo is right, BPT is actually the symbol for BP Prudhoe Bay Trust, another excellent high dividend position.

Feb 02 11:05 AM

[bill d:]

Perhaps I missed it but another benefit of selling covered calls is you get to continue collecting the dividends - the Canroys pay monthly. I love em.

Feb 02 11:57 AM

[Mark in Hon...:]

In a bear market, I like to write covered calls that are in the money. You can find calls that will pay you a 5% premium for one month and still give you a 5-10% cushion for falling prices. Take for instance GE; Last month I sold 7 covered calls at $1.91 with a $12 strike. I bought GE for $13.09/share. That gave a net 7% premium, which I will keep so long as the price does not fall below $12. If it falls below $12, my premium is reduced, but I keep the shares and will sell more calls as soon as the current ones expire.

I figure if I can average about 5% monthly on calls, I can double the money every 15 months, without even counting any dividends.

Feb 02 12:46 PM

[henarl:]

a believer: Yes if a stock you purchase then crashes, that is a "worst case" scenario. But, if you have been selling covered calls on the way down, you at least have the call premiums to mitigate your loss on the share price. Certainly better than just "buy and hold".

Feb 02 03:07 PM

[MattZN:]

A couple of things to note here.

* Canadian Royal Trusts are getting hit by currency adjustments and by new laws coming online in Canada. Be careful. There are several dozen US names to choose from such as KMP, if you want to stay in the energy sector.

* Volatility in the energy sector, particularly these high-dividend-producin... securities, is not generally high enough for covered-call writing to really be worthwhile verses the risk of losing out on the high distributions. In a sense, the high distributions are being paid in lieu of future increases in the stock or unit price. Dividend-producing securities almost universally have lower volatility (and thus lower options premiums) then on-dividend producing securities. The trick is to find securities that are more volatile then normal that you actually don't mind owning and to sell calls on those.

* Covered calls are best in a sideways market. Remember to stop writing them if the market looks like it is going to recover significantly and/or if you find yourself getting called a lot. Right now we are in a sideways market. Remember that different securities behave differently. e.g. the Dow-tracking ETF DIA behaves differently then IBM, a Dow component.

* It is almost always best to write a covered call at-the-money where the premium is highest, to do it on a more volatile security (to get higher premiums), and to do it while the security is on an up-trend (to get even higher premiums). You lose the premium effect the more in or out of the money you sell the call at. The highest premium is AT the money.

If you are bullish then buy the security, wait for the price to appreciate a little and THEN write the covered call at the money, instead of writing the call immediately. For example, a newbie getting into this methodology would buy 400 shares of DIA when DIA is at 79, wait for it to get to 82, then sell four contracts at-the-money at 82.

* NEVER write calls out of the money. Not ever, for any reason. If you think you want to do this, then stop, take a breath, and wait for the security to appreciate instead.

* If you are currently bearish but want to scale into a position then a good strategy is to overbuild the stock position, NOT wait, and sell bearish in-the-money covered calls only on PART of the position. Do not go too far into the money or you lose the premium effect. This gives you a little premium and some stock if things go up, and a lot of downside protection if things go down. A good way for a newbie to get started is to use something like DIA. Buy, say, 400 shares of DIA and then sell three contracts in-the-money. As an example, when DIA is at 79 buy 400 shares and immediaely sell 3 Feb or March-78 contracts.

Finally, people just getting started should only sell near-month contracts. Do not sell covered calls several months out. Do not rotate contracts (let the security get called, wait for a retracting, then repurchase). Do not sell contracts covering more then 25% of your portfolio at any given moment or more then 50% of any single security (unless you want to sell the security), or 75% of the quantity of any single security that you have just recently purchased. It takes about 6 months of doing this sort of thing to really start to understand the dynamics of covered-call writing.

-Matt

Feb 02 05:53 PM

[granger:]

look at a collar

buy a basket of good dividend payers, buy puts to protect them, then write covered calls to help pay for the puts, then collect the divvy's

simple, no, but that has been my strategy for the last year

luckily, due to market conditions, I have not had positions called away, yet

Feb 03 06:38 AM

[svosavvy:]

yes yes all correct, you could also do bull call spreads to limit getting taken out in a rising market. You could sell your covered calls at a lower strike for more profit while simultaneously buying a strike a few ticks above so you don't get pinched out in a wild upswing and pocket the spread which is some nice action especially like earlier mentioned if you are holding a high yielder you pocket the distribution too. I would love to do this with one of my positions pvx but the strike spreads are way wide on it and nearly illiquid (thinly traded).

Feb 03 11:19 AM

[Conan the B...:]

I'll stick with my CanRoys: within 2 years, one can get the payout of 8 years worth of consumer staple dividends compounding is 3 times as fast.

And if the Canadian laws are indeed implemented as passed, I will be stuck with oil companies with proven reserves and ongoing production. I also believe that 2 years from now oil will be selling 100% higher than where it is right now, so I expect them to be at least 50% higher. Which is more than I can expect from the staid but true Consumer Staples sector.

JNJ, I would list as a Pharma.

Feb 03 01:51 PM

[Mad Hedge F...:]

The longer crude stays below $40, the more production is being taken off the market. At this stage all 35 million barrels of storage at the Cushing, Oklahoma delivery point for west Texas intermediate are brimming with crude. The 709 million barrel Strategic Petroleum Reserve (SPR) is nearly full. And there is another 50 million barrels stored in supertankers at sea which is building by the day. Demand has collapsed so fast, that oil companies can’t shut down production fast enough. The scary thing about this is that when the next crude spike upward in crude comes, it will be worse than the last one. Take advantage of the current distress prices to accumulate oil infrastructure stocks. Kinder Morgan Energy Partners (KMP) has a PE multiple of 25 and a dividend yield of 8.3%. Enterprise Products Partners (EPD) has a $10 billion portfolio of fractionation facilities, storage, offshore drilling platforms, and 32,478 miles of product, natural gas, and crude pipelines, and carries a modest PE multiple of 12 X and a dividend yield of 9.2%. More expensive Kinder Morgan Energy Partners (KMP) with a PE multiple of 25 X and a dividend yield of 8.3% is also worth a look see.

Feb 20 12:40 PM

[sr9web:]

How's that GE at $13.09 doing?


On Feb 02 12:46 PM Mark in Honduras wrote:

> In a bear market, I like to write covered calls that are in the money.
> You can find calls that will pay you a 5% premium for one month and
> still give you a 5-10% cushion for falling prices. Take for instance
> GE; Last month I sold 7 covered calls at $1.91 with a $12 strike.
> I bought GE for $13.09/share. That gave a net 7% premium, which I
> will keep so long as the price does not fall below $12. If it falls
> below $12, my premium is reduced, but I keep the shares and will
> sell more calls as soon as the current ones expire.
>
> I figure if I can average about 5% monthly on calls, I can double
> the money every 15 months, without even counting any dividends.

Feb 25 01:37 AM