Hedging 5 B-Rated Or Better Stocks With Trailing Yields Over 6%

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Includes: CTL, GCI, PBI, PWE, SDY, SLF
by: David Pinsen

Among the challenges in searching for dividend paying stocks is finding ones that exhibit growth and sustainability in dividend payments. The Earnings and Dividend Ranking system by Standard & Poor's starts with a computerized scoring process to measure growth, stability and cyclicality of earnings and dividends over the most recent 10-year period. S&P then reviews and sometimes modifies those scores to account for special considerations a purely mechanical approach might miss. Then it ranks the stocks according to seven grades, from A-plus to C.

As of Friday's close, there were approximately 17 optionable stocks with dividend yields over 6% that were ranked "B" or better by the Standard & Poor's Earnings and Dividends Ranking system. The table below shows the five most actively-traded of those B-or-better stocks, along with the costs of hedging them against greater-than-26% declines over the next several months, using optimal puts.

A Comparison

For comparison purposes, I've added the SPDR S&P Dividend ETF (SDY) to the table below. First, a reminder about what optimal puts are, a note about another way to hedge high yield names, and an explanation of the 26% decline threshold. Then, a screen capture showing the optimal puts to hedge one of the names below, CenturyLink, Inc. (CTL).

About Optimal Puts

Optimal puts are the ones that will give you the level of protection you want at the lowest possible cost. Portfolio Armor uses an algorithm developed by a finance Ph.D. to sort through and analyze all of the available puts for your position, scanning for the optimal ones.

Another Way To Hedge High Yield Names

Optimal puts are worth considering if you want to hedge your downside without capping your upside. If you own a high-yielding security mainly for its income though, and are willing to cap your upside, you may be able to reduce your net cost of hedging by using a collar strategy: Using the income gained by selling a call option to offset the cost of buying a protective put option. We have been testing an extension to Portfolio Armor's algorithm that will enable users to scan for optimal collars as well as optimal puts. Once it's live, it will be interesting to look at the costs of hedging these names using optimal collars.

Decline Thresholds

In this context, "threshold" refers to the maximum decline you are willing to risk in the value of your position in a security. You can enter any percentage you like for a decline threshold when scanning for optimal puts (the higher the percentage though, the greater the chance you will find optimal puts for your position).

Often, I use 20% thresholds when hedging equities, but one of these stocks was too expensive to hedge using a 20% threshold (i.e., the cost of hedging it against a greater-than-20% drop was itself greater than 20%, so Portfolio Armor indicated that no optimal contracts were found for it). There were optimal contracts available for all of these names using a decline threshold of 26%, so that's the threshold I've used below.

The Optimal Puts for CTL

Below is a screen capture showing the optimal put option contract to buy to hedge 100 shares of CenturyLink against a greater-than-26% drop between now and October 19th. A note about these optimal put options and their cost: To be conservative, Portfolio Armor calculated the cost based on the ask price of the optimal puts. In practice, an investor can often purchase puts for a lower price, i.e., some price between the bid and the ask (the same is true for the rest of the names below).

Hedging Costs and Yields as of Friday's Close

The hedging data in the table below is as of Friday's close, and are presented as percentages of position values. The yields were taken from Fidelity's screener and are as of Friday's close as well. Note that Fidelity's methodology in calculating dividend yields is to annualize the most recent dividend payment, and that this may not always be indicative of future yields. Bear in mind also that the yields below are annualized, but the hedging costs below aren't.

As the table below shows, SunLife Financial (SLF) is extremely expensive to hedge now. If you own it as part of a diversified portfolio - and are content to let that diversification ameliorate your stock-specific risk, but are still concerned about market risk - you want to consider buying optimal puts on an index-tracking ETF (such as SDY), as a way of hedging your market risk.

Symbol

Name

Div. Yield

Hedging Cost

PBI Pitney Bowes 10.7% 3.95%*
CTL CenturyLink 7.45% 1.16%*
PWE PennWest Petrol 7.68% 5.49%***
GCI Gannett Co. 6.16% 5.39%*
SLF SunLife Financial 6.80% 25.8%**
SDY SPDR S&P Dividend 3.11% 1.55%*
Click to enlarge

*Based on optimal puts expiring in October

**Based on optimal puts expiring in November

***Based on optimal puts expiring in December

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.