We all like the dividends, right?
OMG NELSON YOU HAVE NO IDEA I LITERALLY LOVE TO HUMP DIVIDENDS OH BABY.
That reaction is a little over the top, but hey. It’s probably pretty accurate.
I’ve came out before in my opposition of dividends. I used to think people who insisted on every stock they own paying a dividend were uninformed and setting themselves up to accept lower returns going forward. After all, dividend-paying stocks sure have been helped by a 30-year decline in interest rates. Thousands of retirees have abandoned GICs and government bonds, searching for the yield they need to survive in this pension less world.
But I’ve softened my stance over the last little while. It’s actually gotten to the point where I prefer to invest in companies that pay a dividend. I like getting paid to wait for whatever stupid little value stock I own to recover. I then reallocate that capital into other investments, creating my own compounding machine in the process.
Thanks to low interest rates and our terrible savings rates, stocks that yield between 5-10% are more popular than eating bacon while watching some show about zombies. Isn’t that what you kids do? I dunno.
But there’s a problem with these kinds of companies. Big yields tend to equal big risks. Sure, you can analyze the financials to see whether the company can afford the payout, but that’s hardly a foolproof method. Earnings aren’t guaranteed, neither are dividends. Management can and will cut payouts.
So you have a problem. You need a lot of yield from a portfolio, but you don’t want to take huge risks to get it done. What’s an investor to do besides wet themselves with fear?
Well, there are several strategies. Let’s look closer at using covered calls to get enough income to finally get the ladies at the retirement home to notice you.
What are covered calls?
Great question, guy who just asked that. Give yourself a raise.
Before you read this, go ahead and verse yourself on the basics of option market. Or not. Whatever, it’s a free country.
Covered calls work a little something like this. A call option gives you the right to buy a certain stock at a certain price on a certain day. If you straight up buy calls, you’re essentially making a bet that the underlying stock goes up in value.
You can also sell a call, which means you collect the premium up front in exchange for locking in a certain selling point of the underlying security. This is a dangerous thing to do unless you own said security.
If you do own the security, you’re writing what’s called a covered call. I promise, this will make more sense once I show you a specific example.
Okay, say you owned 100 shares of Telus, a stock currently trading for $40.25. The $42, May 20th call option currently trades hands at $0.22 per share. What you’d do is you’d enter into a transaction to sell the call option, collecting $22 today in exchange for agreeing to sell your Telus shares at $4,200 on May 20th.
Still with me? Good. Okay, one of two things can happen. Telus shares can end the next month at less than $42 or more than $42.
If Telus shares end up below $42, this is a good trade to make. You’ll collect your $0.22 per share premium with no consequences. FREE MONEY BABY. If you repeat that trade over and over again each month or each quarter (some shares have monthly options, but most don’t), it’s easy to see how you can really goose your dividends. Add the call premiums to Telus’s already generous dividend and you get a total yield of approximately 10%.
The issue with a covered call strategy is when shares go up. If Telus closes at $42.01 on May 20th, you’re forced to sell your shares for $42. This isn’t so bad on the surface, since you’ve still made a gain of $1.75 per share plus the $0.22 per share option premium you collected at the beginning. Not a bad profit for a month, right?
But what happens if me and all my rich friends decide we’re going to acquire Telus at $50 per share? This offer would send shares soaring, leaving you kicking yourself for agreeing to sell at $42. You’d be missing out on a lot of excess return.
This is precisely why a covered call strategy is more popular for big, mature, boring blue chip stocks like Telus. Shares of such companies don’t tend to move that much.
That’s covered calls in a nutshell. Essentially you’re exchanging income now for potential capital appreciation in the future.
The easier strategy
Those last paragraphs were kinda complicated, right? I bet you didn’t even read them. You did? LIAR. DON’T LIE TO ME I CAN SMELL LIES.
So instead of doing the hours of work it would take to implement your own covered calls strategy, just take the lazy way out. Pay some guy to do it for you.
There are plenty of options. The first is a closed end fund ran by former Dragon’s Den star Brett Wilson’s company, Canoe Financial, called the Canoe EIT Income Fund (TSX:EIT.UN). Shares of this closed end fund trade at $10.49 each and it pays a monthly dividend of $0.10 per month. That’s good enough for a yield of 11.4%.
There’s one simple reason why I like this fund, and it’s not because of the management fee, which is north of 1%. It’s because the net asset value of it is currently $12.32 per share, meaning you’re buying shares of really easy to value companies at a discount of about 20%. Each year, the fund gives unit holders the right to redeem shares at 95% of NAV. The offer is always oversubscribed, but on average, about 20% of units tendered get redeemed. It’s a nice capital gains perk for a product that’s just supposed to be about the income.
BMO has at least two covered call ETFs, the Canadian banks covered call ETF (TSX:ZWB) and the covered call utilities ETF (TSX:ZWU). The utilities ETF yields close to 7%, while the bank ETF is closer to a 5.5% yield, something that’s not very interesting considering the banks themselves yield about 4%. Both beat the Canoe product in management fees (coming in at 0.65%), but lose big time in yield. Since these are income-first products, yield matters. A lot.
All of these products have cut their income over the last five years as more and more people use the options market in an attempt to generate income. So don’t go thinking that a covered call strategy is something you can count on. It has the same sorts of risks inherent with other forms of investing.