Federal Reserve Chairman Ben Bernanke signaled this week confidence that inflation is headed lower reducing fears of higher interest rates. I wouldn’t be surprised if we see the potential for lower rates as we head into the summer months.
Even after a dozen rate hikes by the Fed over the last three years followed by no increases, bond yields still remain at relatively low levels, with the long bond.
New Classes of Double Digit Income Securities
It's not surprising to see new classes of securities emerge that are custom-tailored to pay much-higher yields than traditional investment to satisfy the appetite of income-oriented investors.
Many folks need a lot better than 4% to 5% to meet their retirement goals, and therefore will take some risk to achieve higher yields.
I want to introduce a class of security that fits right into our search for listed securities that pay out a dividend yield of at least 9%, with the goal of obtaining another 15% upside appreciation in a one-year period. I'm talking about managed option income funds.
These funds buy stocks and sell, or "write," options on them, pocketing the payments, or "premium." With that income, some funds are already yielding 9%-11%, which is awfully attractive in today's low-yield market. Just this year alone, Wall Street has more than $9 billion for some 15 closed-end "buy-write" or "covered call" funds that use this strategy and that are all listed on the NYSE.
The number of available option income funds will grow to more than 25 by over the next year, providing us many choices. Most of the current funds went IPO 2 years ago and underperformed due to the influx of new funds in a sloppy market. But starting in 2006 they began to stabilize with the broader market and are, in my view, starting to look attractive.
This is not the first time option income funds have made their way to Wall Street. They were once popular in the '80s, but fund managers back then only bought stocks that carried the highest premiums, which meant they were in the riskiest stocks. The crash of 1987 brought an end to that wild west strategy, and today's managers shoot for solid underlying stock performance and not just ballistic income.
Various funds take different approaches to how they execute their covered call strategies. Some will buy dividend-paying stocks and sell only index options against the portfolio. This way they never run the risk of being called away.
Pretty smart, huh?
Other funds combine dividend-paying stocks with convertible bonds to lower the volatility. One such name in the group that has caught my eye is the S&P 500 Covered Call Fund (BEP). It invests in all the common stocks that make up the S&P 500, and then sells the SPDR calls against the basket of stocks. Because of the volatility in the market this year, the option premiums have expanded, providing for excellent yields.
Currently, this fund, which carries a $300 million market cap, has an average annual yield of 10.1% -- not bad for a managed option account that pays monthly. And if the market just keeps grinding gradually higher, as I believe it will, then this strategy is appropriate for our model portfolio.
Another well-managed option income fund is the BlackRock Global Opportunities Equity Trust (BOE), which sports a yield of 8.1%. The fund buys foreign stocks and sells covered calls on them all over the globe, so you can have some foreign exposure that pays well at the same time.
When we are selling covered calls on common stocks, we want those underlying stocks to appreciate, but not so quickly as to have the stock called away. The idea is to try to capture the call premium each month without losing the stock. This way you maintain long-term capital appreciation on the underlying common stock while using mini-rallies to sell covered calls and take in premium. It's very much a timing game with this strategy.
Risk vs. Reward
Keep in mind that option income funds carry higher degrees of risk than most other types of income vehicles. The underlying holdings are stocks, which are more volatile than bonds and have a higher risk of losing your principle. But when rates are low, such as we're seeing in the current environment, then the only way you are going to generate more income is to take more risk. There is no free lunch, but good research and good timing can make the difference.
In essence, by investing in option income funds, investors are willing to forgo big gains when the market rallies in lieu of higher current income. In periods where the market rallies strongly, you can bet most of the stocks will be called away, meaning the fund manager has to put on new positions at higher, less-attractive levels.
When purchasing option income funds, I recommend that you resist getting in on any IPOs. As brand-new funds, they haven't yet set their dividend payout, much less invested the monies they have raised. Also, the underwriting fees, as much as 8%, are buried into the initial offering price. Older closed-end funds have already sold off to reflect those fees, so buy the seasoned funds that have been public for at least six months.
This is just another way you can diversify your income-oriented assets and get the kind of returns we need to accomplish our retirement goals. Don't settle for 5% when there are astute methods by which we can double that yield and still grow our assets.
Stay tuned for more.
Bryan
