Don't Reach For Yield – Take the Easy Dividends and Option Premium

Yield oriented investors have had a tough time since the financial crisis in 2008.  The old adage, “Don't fight the Fed,” has rung true as the central bank intervened in the bond market to keep interest rates artificially low. In order to prop up the economy and allow the United States to service its skyrocketing sovereign debt, the Fed has been actively buying U.S. Treasuries and mortgage bonds, ballooning its balance sheet and destroying savings rates for investors.

So where is an investor to go for yield when rates are so low and there is abundant interest rate risk in the bond market?  If he stays short he is paid next to nothing and if he extends duration, he is taking on risk that his principal value will fall significantly when rates rise eventually.

I can remember very well when I entered the business in 1994 when investors in “safe” bond funds lost 30% in a very short period of time.  If the investor goes down in credit quality for yield, his credit risk increases as well.  Bonds in this environment are usually cheap for a reason.  I say stay out of the bond market all-together.  There is no value there.  Instead, look to equities and collect dividends.  Run a screen and look for the highest yielding large-cap, blue-chip companies; that is where you can find income in this environment.  If their yield is high, that means the stock price is possibly depressed for some reason.

An investor can collect 2-4% dividends on very high quality companies compared to savings rates of near zero.  Also try and find a stock chart that shows a sell-off and then a long period of building a base.  This means the stock very likely has found a near-term bottom.

At the same time, investors can further increase their income, while decreasing risk, by selling covered calls on these blue-chip equity positions.  By selling the option that the stock could be called away from you at a higher price, you collect a premium.

With the market hitting all-time highs and the volatility index at very low levels, it is probably a good bet that you will not be called away any time soon as the equity market is most likely topping out at some time in the near future.  If the equity markets sell off, you have limited your risk by buying undervalued stocks, collecting a nice dividend and additional call premium.  If the markets rally and you are called away on your position at a higher level, the worst thing that can happen is you have bought low, sold high, collected dividends and an option premium.  That's better than a sharp stick in the eye!

Finally, buy several equity positions to further diversify your risk; somewhere between 10 and 15 positions is perfect.

The bottom line is that if you are on a fixed income or an investor who has expenditures that require cash flow, there are other options in these markets besides buying fixed income that offers very low yield and comes with a ton of interest rate risk as well.  The combination of high-yielding, blue-chip equities and collecting option premium through selling covered calls can provide a much higher level of cash flow.

This strategy doesn't come without risk as equity markets definitely have a downside; however, you can minimize that risk by buying out of favor companies and selling options to give yourself a cushion.  Interest rates only go from 20% to zero once in a lifetime.  With rates close to zero, the only way to go is up and your principal is at risk.  As they say on Wall Street, “Interest rates are low until they're not.”

L. Todd Wood is a former emerging market bond trader who now writes historical fiction novels.