Collecting A 12% Yield In Plain Sight

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Includes: KO, MS, SPY, T, VZ
by: Eli Inkrot

Summary

Current interest rates are quite low.

An alternative for long-term investors has long been the equity side of the equation, routinely offering yields in the 1% to 5% range.

This article demonstrates a way that you could substantially increase this cash flow.

I don't have to tell you that current rates are low, but I will anyway. According to bankrate.com, the highest national rates on money market accounts or short-term CDs hover just above 1% and a one-year treasury is less than that. For an emergency fund, or other set of funds in need of short-term liquidity, this sort of yield is what you have to put up with. Yet, for additional capital - money available to be deployed over long time periods - you can do much better.

For instance, your basic low-cost index fund (NYSEARCA:SPY) has a dividend yield near 2%. And there are plenty of opportunities to increase this amount: say, Coca-Cola (NYSE:KO) with a 3% yield, Verizon (NYSE:VZ) with a yield above 4% or AT&T (NYSE:T) with a yield around 5%. Beyond that you could start thinking about preferred shares. Naturally total return could be an important consideration as well, but the idea is that presently there are numerous opportunities for the long-term investor to achieve a cash flow stream well above what you would achieve in a short-term account.

This is where a good deal of investors stop. We're used to working in the 1% to 5% range or thereabouts when it comes to dividend yields, as that's where the majority of dividend payers tend to trade. Occasionally, you'll see a higher yielding security, but often that comes with the simultaneous expectation that the payout is apt to be more speculative. (You don't see Coca-Cola trade hands with an 8% yield.)

Yet this doesn't have to be the case. You can both own (or agree to own) higher quality firms with well covered dividends and also generate significant cash flow. I'll give you an example using Morgan Stanley (NYSE:MS).

Some might argue the "higher quality" portion given what happened during the recession, but it follows that the company is only paying out about a fifth of its profits as a dividend. The point isn't really about Morgan Stanley, it's about illustrating that you can find much higher yields in somewhat overlooked areas (at least for the typical dividend investor).

Based on a share price of around $25 and a $0.15 quarterly dividend, the "current" dividend yield now sits at 2.4%. If you suspect that this price offers a "fair shake" for the investment firm, you could become a partner in the business (buy shares) and hold for the years to come. Your cash component would start off at 2.4% and perhaps rise over time.

Alternatively, you could get paid to agree to buy at today's price. This doesn't guarantee that you'll own shares in the future, but it can provide a pretty solid upfront cash flow.

At the time of this writing, if you look at the January 20th, 2017 put option for Morgan Stanley with a $25 strike price, it has a bid of about $3. So by agreeing to pay $2,500 for 100 shares in the next 10 months, you would receive $300 (less fees) upfront, good for a 12% yield that's yours to reinvest or spend as you please.

This sort of thing isn't talked about often, but I find that it can be helpful to clarify your underlying goals. The first step is deciding whether or not you would be happy to own the underlying company. Without this part, the available options likely wouldn't be attractive. However, if you're willing to own shares at the current price, your alternatives are greatly expanded.

One of two basic things would occur if you decided to make this agreement to buy at $25 in the next 10 months: either the option is exercised or it is not.

If the option is not exercised (as would be the case if the share price remained above $25), you would not purchase shares. That's a downside. If shares subsequently jumped to $30 or $40, you might be kicking yourself for not buying shares today. Yet not all is lost. By making the commitment, you still received $300 (less fees) per contract. In comparison to a good deal of other possibilities, this would hardly be a tragedy. Show me a 12% return every 10 months and I'll show you a place to generate substantial wealth.

Alternatively, the option could be exercised (as would be the case with a price below $25). This is why it's paramount to be happy to hold the underlying shares. If the price drops to $20 and you sell, that doesn't do you much good. Yet if you're happy to continue holding, your return will always be higher in this scenario as compared to simply buying shares today.

Your cost basis will be lower and you'll be up ~$2.40 to ~$3 per share depending upon whether or not you also collect dividends during this period. A negative return is still possible, but the total return would be higher than simply buying and holding.

In my view, those are pretty reasonable outcomes: either you collect a 12% yield in less than a year, or you get to own shares in a security that you wanted at a lower cost.

Of course, you're not bound by this single strike or expiration. Instead of agreeing to buy at $25, perhaps you would be more comfortable with $23 or $20. In these scenarios, you could collect a 9% or 6% upfront cash flow stream for agreeing to buy at an 8% or 20% lower price. The option premiums may be taxed differently than qualified dividends, but it follows that you can still achieve a much higher cash flow.

Or you could look at closer expiration dates, as many investors happen to prefer. The October 2016 expiration with a $25 strike price for Morgan Stanley has a bid of $2 - good for an 8% yield in seven months. The July 2016 put option with the same strike has a bid of $1.85 - equal to a 7.4% in four months. Or the April 29th expiration with the same strike has a bid of $1.15 - good for a 4.6% immediate cash flow in the next month. Note that I kept it simple and did not take out fees or fluctuations in these instances, as that varies by individual.

It should be underscored that I'm not recommending any of these options or even the security. However, for those who would like to partner with Morgan Stanley (or any business) at the current price, this sort of thing can be useful to check in on. It may very well be that you look at the alternatives and decide to go ahead and buy shares outright.

On the other hand, perhaps you haven't thought about this route and can now learn more about these sorts of agreements. Certainly, the potential cash flow can be compelling. The idea is to look at a wide range of ownership alternatives to see if there's anything of interest out there.

Disclosure: I am/we are long KO, T.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.