This is not your grandmother's
market
.
You can't invest in blue chips like
Procter and Gamble (NYSE:
PG
)
or
Johnson & Johnson (NYSE:
JNJ
)
and expect to receive the same
dividend
yields of 5% or 6% that you could 30 years ago.
In 1981, S&P 500 stocks threw off an average
yield
of nearly 6%. Today, these stocks give you around 2%.
But there are funds that invest in America's blue chips and carry
yields north of 10% in the process.
I'm talking about closed-end
covered call
funds.
These funds generally own a portfolio of solid dividend paying
stocks and generate additional income by selling
call
options on a portion of their portfolio holdings.
The additional income, or premiums, they get from selling options
allows them to pay higher dividends than their underlying holdings
would provide.
For example,
BlackRock Enhanced Capital & Income (NYSE:
CII
)
owns 54 blue chip names such as
Bristol-Myers (NYSE:
BMY
)
,
Kraft (NYSE:
KFT
)
, and
Pfizer (NYSE:
PFE
)
with average yields of 4% to 5%. But the fund pays out an 11% yield
by selling call options on about half of the portfolio stocks and
collecting the premiums.
If the
strike price
(stock price at which the
option
can be exercised) isn't reached because the price declines, the
option expires worthless, and the fund can pocket millions of
dollars in premiums by writing options on the same stocks.
These premiums help offset the decline in the fund's underlying
portfolio, allowing the fund to outperform its equity
index
benchmark
in weak markets.
In May, the S&P 500 lost nearly 7% and volatility, as
represented by the
CBOE
Volatility Index, popped 41% over the previous month. That's the
kind of environment covered call funds can thrive in. And many did,
with 22 of some 31 covered call funds outperforming the benchmark
S&P 500.
In strong markets, the covered call strategy takes some finessing.
A covered call fund runs the risk of getting the stocks
called away
and needing to buy them back at a premium or else buy back the
option at a generally higher price before it's exercised.
As a result, funds that write options against only a portion of the
assets, leaving the other portfolio stocks free to appreciate, are
more likely to outperform in rising markets.
Funds also preserve the upside potential of their holdings by
selling index options instead of individual stock options.
Unlike stock options, which require delivery of the underlying
security, index options are usually settled with cash. That way,
the portfolio holdings can be left to appreciate even if the option
is exercised.
Funds can further protect upside by writing out-of-the-money call
options. The difference between the strike price and the current
market price
is greater on these options than on
in-the-money
(priced below market) or
at-the-money
(priced equal to market) options, which can be exercised
immediately.
As a result, out-of-the-money options don't command as much of a
premium but allow the underlying stock or index to appreciate
typically around 1% to 3% before being exercised.
With these pointers in mind, I screened for covered call funds with
strategies that position them to generate positive returns in good
times and bad.
I focused on funds that:
1.
Write options on 60% or less of portfolio holdings, leaving the
rest free to appreciate in an up market.
2.
Write index options, leaving the portfolio stocks free to
appreciate.
3.
Write mostly out-of-the-money options, allowing some
appreciation
before the option is exercised.
Here's what I found...
The top performer,
Cohens & Steers Global Income Builder (NYSE:
INB
)
bears watching. INB invests in a portfolio of global large-cap
companies with relative stability. It's also the only one on my
list that uses
leverage
to enhance returns.
As a result, INB has performed best in rising markets when the
fund's leverage helps boost returns. In 2009, the fund delivered
total returns of 67%, more than twice the S&P 500's 27%. If
history is any gauge, a market recovery this year or next could see
the fund strongly outperform once again.
Risks to Consider:
As with all investments, these funds aren't without risk.
Covered call fund distributions generally contain large doses of
return of capital
. Therefore, it's important to check the fund's
balance sheet
to see if the return of capital is reducing its
asset
base.
Action to Take -->
If you're looking for a creative way to invest in America's largest
companies, and boost your yields in the process... a covered call
fund could be a suitable investment idea for you.
-- Carla Pasternak
Carla Pasternak does not personally hold positions in any
securities mentioned in this article. StreetAuthority LLC owns
shares of PG, JNJ in one or more if its "real money"
portfolios.