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Investors should require exceptional returns to bear tremendous risks. Yet somehow the bond market has failed to demand high yields to bear looming interest rate risk. Despite this risk, many investors seeking yield feel that they have no choice, and prefer the perception of safety provided by bonds. Their actions are particularly tragic since the Treasury yields remain low even after the recent rally.

Fortunately, volatility has also dropped, affording opportunities to construct Treasury-beating options strategies on dividend stocks. The simultaneous purchase of a stock, writing a call option, and buying a put option creates the option strategy known as a collar. This strategy has limited upside and downside, which if constructed carefully on the right stocks is more attractive than buying a Treasury. Several dividend paying basic materials stocks were used to construct collars in a prior article, thereby providing a means to beat Treasury bond payouts. This procedure is extended in this article for a mix of five stocks which hail from different industries. The following criteria were taken into account for comparison with the 10-year Treasury:

Higher yield. The options strategy must provide a higher yield than the 10-year Treasury on the net initial investment. To this end, stocks were selected which have a higher dividend yield than the 2.18% bond equivalent yield of the 10-year Treasury. Stocks were also screened for payout ratios at or below 0.50 to allow for dividend growth or slack in the event of a downturn.

Better upside potential. The option strategy must allow for more appreciation in the value of the total position than is available to the 10-year Treasury. Based on the current rate, a 10-year Treasury bond would appreciate 6.3% if its bond equivalent yield dropped to 1.5%. (This is below its historical low of 1.695%.) Thus, a superior option strategy must allow for a 6.3% appreciation in price.

Better downside protection. The put component of the strategy must limit the potential loss of the position to less than could be lost in the Treasury if interest rates bump up to 5%. Based on the current rate, a 10-year Treasury bond would drop 22.0% if its bond equivalent yield rose to 5%. There is the possibility of even more downside in Treasuries from further rate increases, but this is a good number to start with.

The following five stocks were found to provide the right mix of dividend yield and available options to construct attractive collars:

Ticker

Company

Industry

Dividend Yield

Payout Ratio

AFL

AFLAC Inc.

Accident & Health Insurance

2.83%

0.29

ESV

Ensco plc

Oil & Gas Drilling & Exploration

2.83%

0.49

ETN

Eaton Corporation

Industrial Electrical Equipment

3.03%

0.34

MTB

M&T Bank Corporation

Regional - Northeast Banks

3.26%

0.45

NSC

Norfolk Southern Corp.

Railroads

2.84%

0.30

Stock and option prices for each are provided below:

Ticker

Call Bid

Call Strike

Call Expiration

Put Ask

Put Strike

Put Expiration

Stock Price

AFL

2.75

50

Jan 2013

2.63

40

Jan 2013

46.64

ESV

4.6

55

Jan 2013

2.45

42

Jan 2013

52.95

ETN

2.35

55

Jan 2013

2

40

Jan 2013

50.12

MTB

4.3

90

Jan 2013

2.85

70

Jan 2013

85.97

NSC

3.7

70

Jan 2013

2.75

55

Jan 2013

66.3

The combination of buying the stock, selling the call, and buying the put creates the following payout and adjusted dividend yields:

Ticker

Position Net Cost

Max Value

% Gain

Min Value

% Loss

Adjusted Dividend

AFL

46.52

50

7.48%

40

-14.0%

2.84%

ESV

50.8

55

8.27%

42

-17.3%

2.95%

ETN

49.77

55

10.51%

40

-19.6%

3.05%

MTB

84.52

90

6.48%

70

-17.2%

3.32%

NSC

65.35

70

7.12%

55

-15.8%

2.88%

Consider the options strategy suggested for AFL. Instead of buying the stock alone for $66.30 and hoping that swings in the stock price tumble to zero, an investor could opt to create a collar.

The collar could be created through the purchase of AFL stock for $46.64, buying the put at $2.63, and selling the call at $2.75. The net cost of this position is $46.52, which is $0.11 cheaper than buying the stock by itself. The benefit of the additional option trades is a floor on losses, which are limited to 14.0%. The yield on this position is 2.84%.

Each of these positions has less downside and more upside in capital appreciation than a 10-year Treasury based on 5% to 1.5% interest rate scenarios. Furthermore, each of these stock collar positions provides a higher yield which could benefit from increases in dividend policy. Fixed income investors should consider these positions as attractive bond alternatives which they can use to supplement their income portfolios, reducing interest rate risk.

Disclaimer: This article was written to provide investor information and education, and should not be construed as investment advice. I have no idea what your individual risk, time-horizon, and tax circumstances are: Please seek the personal advice of a financial planner. This article uses third-party data and may contain approximations and errors. Please check estimates and data for yourself before investing.

Source: 5 Diversified Dividend Collars To Beat Treasuries