Much has been made about the paralysis of lending by banks in both Great Britain and the United States. Balance sheet repair is certainly a significant part of the credit smackdown that is dominating financial news and creating in some a sense of desperation. The other half of this bitter pill is that..well..no one trusts anyone else. I have the feeling that long after people have forgotten what TARP represented the name Bernie Madoff will stand as a testament to investment fear, gullibility and anger. There are two schools of thought (at least) on the lending issue.

The first counsels caution on the part of Governments and goes like this: Banks know lending (please try and keep a straight face) and will begin making committments when its prudent and they feel secure in their financial status. Let's not get burned again. Liquidity will move through the general system (financial to business to individuals/families and back to business and the payback to financials) the way it always has. This is the Historical Guide Model. Slow and steady.

The historic occurrence of closed-end fund discounts reaching lows during year-end proved extremely opportunistic once again. In fact, investors who normally wait for year-end to purchase funds at 15% discounts, the traditional approximate discount floor, were met with levels significantly cheaper numerous times throughout the year.

Interestingly but not surprising, discount levels of funds were blind to asset class, NAV movement, etc. While there was great concern on funds that use leverage, funds that didn’t use leverage were equally as discriminated against. Even funds whose NAV held up incredibly well (for example, the Eaton Vance Risk Managed Diversified Equity Income Fund (ETJ)) were sold off to extreme levels at times. Oh, the beauty of an inefficient product/sector….

Many income investors are looking for monthly dividend payments to support their income during retirement. Other pre-retirement investors want monthly dividend stocks for their IRAs for faster compounding.

This list is now up to 150 different stocks, CEFs, REITs, floating rate funds, and oil income funds [such as Canadian royalty trusts], all of which are traded on the New York Stock Exchange or the American Stock Exchange. I've added over twenty new securities since the year-end update, reposted the yields, kept the readers' recommendations of sorting by yield with the highest first, and identifying the Canadian companies [due to tax withholding issues].

Due to requests from readers, I have sorted the list by yield, from highest to lowest. In addition, I have identified the Canadian trusts due to the tax withholding issue which can significantly affect the yield, especially with regard to holding these Canadian Oil Income Trusts in retirement plans (they all trade in the U.S.). The list shows the name of the stock, the stock market symbol, the yield, and if the stock is Canadian.

For anyone who researches their own investments, the closed-end funds would probably be preferable because they won’t have the big sales charge and the recurring 12b-1 fees of the Van Kampen fund. Plus, once again, closed-end funds have the advantage of a stable asset base on which the calls can be written.

The general concept of selling call options against your portfolio is just fine—it’s the fact that many people do not grasp the implications of this strategy that bothers me. In particular, I have now seen a number of articles and gotten the explanation from a number of folks that state that the premiums that you collect when you sell covered call options can be regarded as income and treated, therefore, like dividends. This is an enormous misconception and it likely to end in a lot of hard feelings when either (1) the market rallies, or (2) volatility increases. At first, I thought that I did not understand what was going on when I read proposals that treated dividend income and option premium as similar sources of income in the portfolio. I have now seen and heard this explanation a number of times --- I get what these managers are doing -- and the pitch is often patently incorrect. To treat dividends and option premiums as the same thing in looking at a portfolio is an apples and oranges comparison.

Dividends are earnings returned to shareholders—they are true income. Option premiums are not the same thing. When you sell an option, you are selling what is called a ‘contingent claim’ against your portfolio. This means that in return for the option premium you are paid, you have a future obligation to the option buyer to sell him your shares at a specific price. Dividends are income with no future claims. I thought of a nice example to show how ridiculous it is to treat option premium as pure income. Imagine if you pay your homeowner’s insurance on January 1, 2006. Does your insurer treat this as income? Of course not. Your insurer has provided you with a contingent claim. If your house burns down, they will pay you some money. The insurer is like the investor selling a covered call. The insurer/call seller receives a premium in exchange for the promise that can potentially be costly to fulfill (building you a house or buying back your stock). When you sell a contingent claim, you must keep most or all of the premiums you collect in anticipation of the day when you have to fulfill the claim against you. The insurer banks the majority of the premiums he collects as reserves against disaster and you, the investor, should bank the vast majority of the premiums you collect from your covered calls against the day when the calls are exercised. An insurer who treats collected premiums as pure income is committing fraud.

As you start to look at these funds, it seems that there are two basic philosophical viewpoints:

Scenario 1: Efficient Market

In the most simple-minded scenario, options are always priced efficiently in the market—they trade at ‘fair value’. The fund sells covered calls and makes money from option premiums. The fund also loses the potential upside from the movement of the stock price above the strike of the options. The fund also generates an income stream from dividends. If the market is efficient, there will be no net gain to this strategy over time. You will tend to look good when the market shows low volatility or is in decline and you will tend to look bad when the market rallies or when volatility is high. In this case, a fund that sells covered calls will end up, in the long-term, providing lower total returns with lower volatility than simply holding the basket of assets.

Nature of the beast: Closed-end funds are offered at a premium to NAV at their IPOs; the premium represents the compensation to the underwriters, although few retail buyers understand this. Afterward, closed-ends frequently fall to discounts in the aftermarket.

Lack of investor understanding: Wachovia Securities analyst Mariana Bush says, "We think investors are selling their funds regardless of their NAV performance, to get rid of holdings whose behavior they cannot fully understand."

Wall Street maneuvers: A 1994 study by the Wharton School of Finance suggested that "enterprising" pros sell these funds to a "less informed" public. More often than not, these premiums disappeared when the underwriters withdrew so-called price support techniques after the offering, leaving the small investors holding the bag... Thomas J. Herzfeld places the blame for the current depressed prices squarely on Wall Street. "The underwriters pumped out whatever they could sell leaving no demand for these shares in the aftermarket."

Overly-high risk in pursuit of high yields: "Most of these funds have little or no chance of returning their eight, nine, ten percent yields without depleting their respective net-asset values," says another Chicago options trader.

The Businessweek dated July 4 has an article (I don't know if I utilized my subscription to access the article) about closed end funds that sell call options to create income, writes Roger Nusbaum. I have written about this product numerous times because I think it can be useful in a properly diversified portfolio.

My wife spent Friday night at a family function that I got out of because our new puppy needs a human present most of the time. So for fun I watched the Diamondbacks game and plugged the term covered call funds into Yahoo Finance to see what I would find.

Any ETFs or Closed-End Funds that we haven't covered that you think we should? Leave a comment below.