My Two Cents - "Income in a Zero-Rate World"

1/30/2009

One look at the yields on US Treasuries tells a good part of the story. Listening to Fed Chief Ben Bernanke gives us the rest: it is going to be very hard making any kind of money in many traditional fixed income instruments using the conventional method of clipping bond coupons. Certificates of Deposit won’t be much better moving forward. It would seem as though we are destined for either zero or near zero short-term interest rates for at least the next year.

At the same time, equity markets have been atrocious. That goes without saying. And it hasn’t just been the US markets either. International indexes have been decimated. Commodities, save Gold, have been hammered as well. There are always FOREX markets, trading options, and futures, but they are risky and often outside the comfort zone of the average investor. So the big question right now is how does one aspire to make any money in the markets given the current realities? Fortunately, there are a couple of strategies that are relatively easy to implement for the average investor. We’ll outline two of them here.

The hedged dividend Portfolio Model

The first is to create a situation where the investor is able to secure a higher rate of dividend income than that of traditional fixed income investments while significantly decreasing the risk to the portfolio. In order to do this, a portfolio of dividend paying assets is selected, and an appropriate hedge is identified to protect the investment. This allows the investor to get a comparatively high dividend yield while providing a higher degree of capital preservation than would otherwise be possible. The problem with hedges is that markets don’t always go down, nor do they always go up. Obviously, when markets are moving higher a hedge will be a boat anchor on any portfolio. Conversely, the absence of a hedge in a falling market will also be a boat anchor. The challenge is identifying the bigger moves and acting accordingly. Back in December, we took at a look at some model portfolios that were based on the investment themes focused on by the financial media during 2008. Of the three, let’s focus in on the energy portfolio, simply because it paid the best dividends of the three mentioned in that article:

This model contains 4 Canadian Royalty Trusts, an oil service company, two Master Limited Partnerships (MLP’s), and an express Trust. The model is heavy on the side of Canadian Royalty Trusts because they have been a popular vehicle for individuals to invest in oil and natural gas.

This model portfolio paid $19.98/share in dividends during the course of the period studied. The assumption for the portfolio is that an equal number of shares were purchased for each issue listed. Let’s say for example that we purchased a round lot (100 shares) of each and a 16% hedge (250 shares) of DUG.

The initial cost of our portfolio on 5/19/08 (recent market high) would have been $41,681.50 plus any applicable commissions. The November 11/20/08 value (recent market low) was $29,490.50 for a loss of $12,191.00 or 29.25%. The dividends paid during that time would have totaled $1,998.00, a yield of 4.79% for just 6 months. Considering the S&P500 lost 47.25% during the same period, the hedged strategy performed much better and produced dividends at an annual rate of 9.58% as well.

Obviously, if the price of oil and natural gas had continued to rise, this would not have been an appropriate move since we would likely have gotten capital appreciation in additional to the dividends but the hedge would have lost significant value. The obvious risk to this type of an approach is that the incorrect hedge is used or a major market signal is missed. The whipsaw of the energy markets underscores the need to be up on the wheel in terms of keeping up with this type of a strategy. While it can certainly pay off, like anything else, it requires constant vigilance. The benefits are obviously the dividends and the knowledge that even if you don’t nail every move; you are still getting paid handsomely to wait until market conditions become favorable. And in the case of energy, you have the conviction of the belief that you are investing in a wasting asset that is becoming more and more difficult to get to market.

Income through covered calls

A second method that investors can use to make money on investments they hold is by writing covered calls. It isn’t as complicated as it sounds. In the interests of brevity, I will present a short primer of how an option works, focusing on calls for the purposes of this article.

A call gives the holder the right to purchase 100 shares of a stock at a given price, or ‘strike price’ for a period of time. For this option, the purchaser pays a premium. Let’s use an example to illustrate. Joe buys a call for Company XYZ at a strike price of $30 that expires in 3 months. The current share price is $28. Joe is speculating that the price of the stock will go up within the next 3 months. If indeed that happens, he can either sell his option to someone else (if it appreciates in value) or, if the price of the shares goes above $30, he can exercise his option, purchase the shares at $30 then sell them on the market for a profit. However, if the share price doesn’t move or goes down, Joe’s option will expire worthless.

Now let’s flip the roles and look at it from the standpoint of the investor who holds the shares. Let’s say that Joe buys 500 shares of XYZ stock at $28/share. What he can do is sell 5 calls (each call is an option on 100 shares) at a strike price of say $35. For selling these options, he’ll receive the premium, which will vary on a number of items such as the volume of options at that date and strike price, the time involved, and other factors.

Joe’s calls are ‘covered’ because he already owns the shares. If the option is exercised, he’ll just surrender his own shares as opposed to having to go out in the market and purchase them (naked call).

In the ‘worst’ case, the stock price rises to the point where the option holder will exercise and Joe will have to sell his $500 shares at $35/share. However, he not only received the premium from selling the options, but he also made $7/share. So his profit is $3,500 plus whatever he made selling the options. If the stock stays under $35, the option will expire unexercised and Joe can sell 5 more covered calls and bring in more premium. For stocks that are stuck in a range, this is a great strategy. Applying this strategy to a dividend-paying portfolio is a great way to enhance income, especially in a down market such as what we are dealing with right now. By combining this tactic with the hedged portfolio presented in the previous example, a fairly stable basket of dividend producing assets with extra income from the covered calls can be created.

Some things to consider

• It is a good idea to sell calls at a strike price that is significantly above what was paid for the shares. The example above is a reasonable one. If the strike price is too close to the current market price, you stand a better chance of getting blown out of your position. You’ll likely bring in more in premium for those options, but the likelihood of losing your position must be weighed. This is especially true if the intent is to collect dividends and supplement the dividend income with covered calls.

• Tax implications must also be considered. Generally for IRA type accounts this is not an issue as all taxes are deferred anyway. However, in the case of an individual taxable account, Joe’s $2,500 gain would be taxed as a capital gain. The amount of time Joe held his shares would determine whether he’d pay the short or long term rate.

• Writing uncovered or naked calls is not generally advisable and is typically more risky because the writer of the naked call has to have the money available to purchase the shares to sell should the option be exercised. For an investor who is looking to augment dividend income, writing naked calls is probably not a great idea.

If there is one silver lining to the current zero-rate environment, it is that consumer prices have not gone ballistic at the same time. The reduction in energy costs have helped consumers immensely and slightly lessened the need for inflation fighting 10-15% returns (see table below).

However, by seeking out these types of returns anyway, investors can begin to either recoup some of what they lost in 2008 or prepare for a future that is at best unclear. Based on recent money supply figures, the assumption that we will once again be entering a period of high inflation is a pretty good one.

Perhaps the most important take home message from this article is that when you buy a stock you become an equity owner in that firm. And it is my belief that equity owners should share in the profits of the firm rather than resting their success solely on the hope that someone will come along at some point in the future and give them more for their shares than they paid.

It must be noted that these strategies are not suitable for every investor. The model portfolio in this article is used for informative and illustrative purposes only and should not be taken as an investment recommendation or offer to buy or sell any security. Always consult a qualified financial professional before making any investment decisions.

Graham Mehl is a pseudonym. He is not an ‘insider’. He is required to use a pseudonym by the policies of his firm when releasing written work for public consumption. Although not an insider, he is astonishingly bright, having received an MBA with highest honors from the Wharton Business School at the University of Pennsylvania. He has also worked as an analyst for hedge funds and one G7 level central bank.

Andy Sutton is a research and freelance Economist. He received international honors for his work in economics at the graduate level and currently teaches high school business. Among his current research work is identifying the line in the sand where economies crumble due to extraneous debt through the use of economic modelling. His focus is also educating young people about the science of Economics using an evidence-based approach.