Financial Investment Opportunities For 2011
Author: Emily A. Johnson, CFP®, ChFC, CLU
Conventional investment wisdom has always stated that investors seeking income should look to bonds – treasuries, high grade corporates – or possibly CDs to meet their needs. Events of the past two years have turned this convention on its head. Yields on CDs and high grade bonds have tumbled to the lowest rates in history, sub 1% for short term maturities. And if you were to purchase a bond at current yields of any maturity, you run a very real risk of principal erosion when interest rates increase, which many economists and other prognosticators believe will occur as the economy continues to recover. So where should investors seeking a stream of cash look for yield without taking on substantial risk? In 2011, equities. Sure, you could find high yields on lower quality or junk bonds, floating rate bonds, or possibly foreign bonds, and perhaps these would provide strong diversification tools for your portfolio, but the risk associated with these bonds exceeds that of the stocks of companies with strong balance sheets. Market and economic factors seem aligned to benefit equities; in addition to dividend yielding equities, covered call strategies create an interesting opportunity for income investors in 2011.
Covered call strategies, put simply, involve an investor purchasing a stock and selling a call option, or the right to buy the underlying stock at a specified price and maturity. When the call option is sold, a premium is paid to the seller whether or not the call, or right, is exercised in the future. Because of this premium, covered call strategies are broadly considered to be more conservative than investing in stocks alone, as the premium income provides some protection from declines in the underlying stock. A few of the factors driving the success of this strategy at the moment include: volatility, a recovering economy, and an improvement in corporate balance sheets.
Though somewhat counterintuitive, volatility is actually good where covered call strategies are concerned because increased volatility typically leads to higher premiums, meaning greater income for the seller of the call option. In fact, many calls can be sold on a monthly basis to generate monthly income for the investor, a convenient alternative to semi-annual bond payments or quarterly dividends. The recovering economy, likewise, strengthens the case for equities and covered calls, as an improved economy generally drives improved corporate balance sheets, free cash flows, and growth opportunities, which in turn drive enhanced returns.
Because individual investors possess unique risk profiles and income needs, this strategy can be customized to fit these risk and return parameters. Traditionally, covered call strategies favor mid- to large-cap growth oriented stocks, since the calls associated with these stocks typically generate the highest premium income. However, these stocks might be riskier than some investors can stomach. One alternative would be to focus the equity portfolio on more blue-chip, dividend-yielding stocks; selling calls on this type of portfolio may generate smaller premium income, but when combined with dividends, offers excellent protection from market declines and generates a steady income. Similarly, a portfolio of exchange traded funds, or “ETFs”, can be used as the basis for a covered call strategy, providing greater diversification than individual stocks while still generating significant, steady income.
With 24 hour coverage of markets, risk and interest rates, investing for income can seem more complicated than in years past. And perhaps it is, as the next few years will likely bring new schools of thought on risk appropriate income generation. That said, opportunities abound for investors willing to consider alternatives, such as a covered call strategy, as a core component of their portfolio.