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Despite reflation and quantitative easing moves by the Federal Reserve and the European Central Bank, somehow the bond market has failed to demand high yields to bear looming, immense interest rate (inflation) risk. Despite this risk, many investors seeking yield feel that they have no choice, and prefer the perception of safety provided by bonds.

Some income investors have recognized that dividend paying stocks are an alternative asset class for income investing. Unfortunately, given the run up in prices and the exuberance surrounding yield in today's markets, investors should tread lightly and try to find ways to limit losses.

Fortunately the options markets provide opportunities to construct treasury-beating option 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. This procedure is utilized in this article for a selection of five stocks. 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 1.71% 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 1.94% if its bond equivalent yield dropped to 1.5%. Thus, a superior option strategy must allow for a 1.94% 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 25.64% if its bond equivalent yield rose to 5%. There is the possibility of even more downside in treasuries from above-average inflation, but this is a good number to start with.

Sustainable dividend payments. The dividend paying stock must not payout more than 60% of earnings as dividends. If a stock had a much higher payout ratio, then declining earnings would be more likely to force companies to slash dividends. Moreover, retained earnings can be used for reinvestment to grow earnings going forward.

The following 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

ETN

Eaton Corporation

Industrial Electrical Equip.

3.28%

0.34

FCX

Freeport-McMoRan

Copper

3.07%

0.34

UTX

United Technologies Corp.

Conglomerates

2.77%

0.31

MMM

3M

Conglomerates

2.51%

0.37

BAX

Baxter International

Medical Instruments & Supplies

2.98%

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

ETN

3.8

50

Jan 2014

2.65

35

Jan 2014

46.29

FCX

4.3

45

Jan 2014

4.1

33

Jan 2014

40.67

UTX

6.25

80

Jan 2014

4.95

65

Jan 2014

77.33

MMM

4.7

100

Jan 2014

3.7

75

Jan 2014

93.94

BAX

3.55

65

Jan 2014

3.2

50

Jan 2014

60.48

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

Ticker

Position Net Cost

Max Value

% Gain

Min Value

% Loss

Adjusted Dividend

ETN

45.14

50

10.77%

35

-22.5%

3.36%

FCX

40.47

45

11.19%

33

-18.5%

3.09%

UTX

76.03

80

5.22%

65

-14.5%

2.82%

MMM

92.94

100

7.60%

75

-19.3%

2.54%

BAX

60.13

65

8.10%

50

-16.8%

3.00%

Consider the options strategy suggested for BAX. Instead of buying the stock alone for $60.48 and hoping that the stock price does not tumble, an investor could opt to create a collar.

A costless collar could be created through the purchase of BAX stock for $60.48, buying the put at $3.20, and selling the call at $3.55. The net cost of this position is $60.13, which is a little cheaper than buying the stock by itself. The benefit of the additional option trades is a floor on losses, which are limited to 16.8%. The yield on this position is 3.00% (annualized).

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, errors, and is not real-time data. Please check estimates and current data for yourself before investing.

Source: 5 Treasury-Beating Dividend Collars