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Despite interest rate risk, many fixed-income investors prefer the perception of safety provided by treasury bonds to the market risk presented by stocks. Regardless, denial about interest rate risk doesn't make it go away. Worse yet, fixed-income investors are getting paid very low yields to embrace the risk of interest rate spikes and plummeting bond prices.

Fortunately, low volatility affords opportunities to construct beating collar positions on dividend stocks, which are more attractive than government bonds in many key ways. The collar position is the simultaneous purchase of a stock, writing a call option, and buying a put option. 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 large-cap stocks were used to construct collars since liquid option markets are more frequently found on stocks with high market capitalization. The options markets of these stocks were trolled for low bid-ask spreads and call prices, which could offset put purchases. These options also had to leave enough upside on the table and downside protection to make the resulting position attractive vis-à-vis treasuries. The following criteria were required to select costless (or near costless) collars:

Higher yield than the 10-year treasury. The options strategy must provide a higher yield than the 10-year treasury on the net initial investment. To this end, stocks were selected that have a higher dividend yield than the 2.21% 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 6.57% 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 21.75% 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

EMR

Emerson Electric Co.

Industrial Equipment & Components

3.11%

0.46

GE

General Electric Company

Diversified Machinery

3.39%

0.50

INTC

Intel Corporation

Semiconductor - Broad Line

2.98%

0.31

LMT

Lockheed Martin Corp

Aerospace/Defense

4.40%

0.41

WMT

Wal-Mart Stores Inc.

Discount, Variety Stores

2.60%

0.32

Stock and option prices for each are provided below:

Ticker

Call Bid

Call Strike

Call Expiration

Put Ask

Put Strike

Put Expiration

Stock Price

EMR

$ 2.70

$ 55.00

Jan 2013

$ 1.95

$ 42.00

Jan 2013

$ 52.18

GE

$ 0.60

$ 22.00

Dec 2012

$ 0.53

$ 16.00

Dec 2012

$ 20.07

INTC

$ 2.35

$ 30.00

Jan 2014

$ 1.96

$ 22.00

Jan 2014

$ 28.12

LMT

$ 2.50

$ 95.00

Jan 2013

$ 1.70

$ 70.00

Jan 2013

$ 89.86

WMT

$ 1.43

$ 65.00

Jan 2013

$ 1.28

$ 52.50

Jan 2013

$ 61.20

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

EMR

$ 51.43

$ 55.00

6.94%

$ 42.00

-18.3%

3.16%

GE

$ 20.00

$ 22.00

10.00%

$ 16.00

-20.0%

3.40%

INTC

$ 27.73

$ 30.00

8.19%

$ 22.00

-20.7%

3.02%

LMT

$ 89.06

$ 95.00

6.67%

$ 70.00

-21.4%

4.44%

WMT

$ 61.05

$ 65.00

6.47%

$ 52.50

-14.0%

2.61%

Consider the options strategy suggested for WMT. Instead of buying the stock alone for $61.20 and hoping that swings in the stock price will not overwhelm its 2.60% yield, an investor could opt to create a collar.

The collar could be created through the purchase of WMT stock for $61.20, buying the put at $1.28, and selling the call at $1.43. The net cost of this position is $61.05, which is $0.15 lower 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 slightly less expensive position is 2.61%.

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: Bond Replication Using Costless Collars