Covered call strategies

By John Teahan

On the eve of the financial crisis an investor could achieve a 5% yield on a two-year US government bond. That is US government credit risk, no liquidity risk, low duration risk and a real yield of over 2%. Today you receive 0.35% for the same bond.

If, as most investors do, you require your capital to generate a return then the challenges to meet even reasonable expectations are immense. Particularly if you are conservatively minded and think about risk of loss of capital as much as about the potential return on capital.

However, many investors focus on the headline yield on an asset and dismiss the potential loss of capital and the resulting loss of income generating ability. This is clear from the recent IMF Global Financial Stability Report. Issuance of poor quality bonds and loans; covenant-lite, second-lien, PIK Toggle notes, CLOs are surpassing the 2007 records.

Where then can investors safely deploy cash to earn a reasonable return? In short there is no such place. As Seth Klarman, a renowned value investor said of the reach for yield in the 1980s: “To achieve current cash yields appreciably above those available from US government securities, investors must either risk the loss of principal or incur its certain depletion.”[1]

Here is where we believe a covered-call strategy[2] can help in the goal of achieving a reasonable return and containing some of the risks of a loss of capital. It is less a risk of the loss of principal and more taking a risk of some depletion, should equity returns not match expectations. However, where we are today the latter may be more sensible risk to accept rather than the former.

The strategy limits participation in a very strong market, as the call options written in exchange for option premia, limit the potential upside. This has been clear over the last two years (S&P 500 +47%, S&P BuyWrite Index +26%, the latter strategy invests the S&P 500 and writes one month ‘At the Money’ call options). However, in weak markets the strategy cushions the down side. In the drawdowns of 2001/2002 and 2007/2009 the strategy outperformed the index by 15% on both occasions.

An investor can withdraw the option premia as income or use the strategy as a means to gain relatively lower volatility equity exposure, reinvesting the option premia along with stock dividends. If the option premia are withdrawn as income then as with any distribution fund the compounding of returns will be lower and capital growth will be impeded. The key is having a sensible distribution rate, too high and you are certain to suffer capital depletion. Such a yield has to be set against expected long-term equity returns and therefore we believe a 6% to 7% distribution yield is both an attractive income and allows for some growth of capital over time.

Match the covered-call strategy with a portfolio of good companies, on low valuations, with reasonable dividend yields and investors get a low volatility equity fund that should give them a much more comfortable experience that many other approaches.

We believe there remain some areas of the equity market that offer such opportunities; pharmaceuticals, telecoms and energy stocks offer decent future returns.

For the investor forced out the risk spectrum, unaccustomed to taking equity risk, or the investor rightly concerned with asset prices today then this strategy is well worth considering.

John Teahan is co-portfolio manager at RWC