The Search for Yield
Given the state of our current economic climate, many high-net-worth clients looking for yield in their portfolios are finding this prospect difficult.Jul. 3, 2021
Given the state of our current economic climate, many high-net-worth clients looking for yield in their portfolios are finding this prospect difficult.
Two factors have combined to make the search for yield a challenge for clients: record-low interest rates and expected inflation.
Inflation is especially concerning as the U.S. Federal Reserve has gone on record stating that in 2021, they will permit inflation to run beyond its 2% target, putting no hard ceiling in place.
The market is currently pricing in an average annual inflation rate of about 2.6% for the next five years. With base rates at 0.25% in both Canada and the U.S., and neither country’s central bank indicating their intention to increase rates any time soon, investors holding short-term fixed income holdings are faced with exceptionally low yields.
When combined with over 2% per year inflation, this can erode capital should the portfolio not yield more than inflation.
Investors have traditionally sought out equities for their ability to provide superior protection from inflation to counter these trends. But the asset classes that do provide that protection are generally low yield. At the same time, current market valuations are high relative to their averages.
In this challenging environment, incorporating an options-based strategy to generate income could prove to be the answer for high-net-worth clients looking for yield.
An overlay options strategy is a proven way to generate higher yields, but this can be a time-consuming and expensive process. ETFs, by contrast, offer that promise of higher yields without the aforementioned challenges.
BMO ETFs manages over $8.6 billion in option overlay mandates, covering a variety of strategies including income generation and risk mitigation. In terms of volume, BMO trades over 800,000 options each month on a variety of underlying securities, including Canada, US and International equities and ETFs. These options include listed and OTC options.
|BMO Covered Call ETF||Ticker||BMO Covered Call ETF||Ticker|
|BMO Canadian High Dividend Covered Call ETF||ZWC||BMO Covered Call Dow Jones Industrial Average Hedged to CAD ETF||ZWA|
|BMO US High Dividend Covered Call ETF||ZWH/ZWH.U/ZWS||BMO Covered Call Utilities ETF||ZWU|
|BMO Europe High Dividend Covered Call ETF||ZWP/ZWE||BMO Covered Call US Banks ETF||ZWK|
|BMO Global High Dividend Covered Call ETF||ZWG||BMO Covered Call Technology ETF||ZWT|
|BMO Covered Call Canadian Banks ETF||ZWB|
High-net-worth clients are going to be best served by a covered call option strategy (or buy-write strategy). This strategy is designed to provide clients with a dual source of cash-flow: an option premium and a dividend yield.
This strategy is implemented by writing a call option contract while owning the underlying stock. It is considered not only a very tax efficient income enhancement strategy (the option premium is treated as capital gain thereby benefiting from a lessened tax burden), but also a defensive strategy, as equity downside returns are reduced by the option premium.
The tax benefits of using an overlay options strategy is more evident in the case of international investing. To highlight the tax advantage on options vs foreign dividends, below is a simple example using a 4% dividend yield vs. a 4% yield consisting of option premiums:
There are two benefits for the option premium:
- Full amount up front (no withholding tax), so no need to pay any tax until year end
- Taxed as capital gain rather than foreign dividends
The BMO covered call strategy strikes a balance between generating income and participating in rising markets.
The strategy writes OTM calls with one to two months to expiry on approximately 50% of the portfolio, as writing shorter time options provides greater flexibility to adjust the options’ strike prices more frequently to capture more upside.
The underlying stock portfolios are either high-dividend yielding, equally weighted sectors, or high-dividend portfolios (based on BMO’s proprietary dividend screening model, which avoids deteriorating companies based on quality and fundamental screening):
The Impact of Market Conditions
Covered call strategies tend to outperform in flat or down markets and underperform in periods of rapid market appreciation.
These strategies are most effective when the underlying stocks are range-bound, as they will participate in equity appreciation up to the strike price, with the added benefit of the option premium. When stocks rise significantly and exceed the strike price, call options move into the money, effectively capping the gain.
When stock prices decline significantly, the strategy will provide limited protection, as the decline will be partially offset by the call premium received.
In an environment where yield opportunities are hard to find and inflation threatens to erode real yields earned on traditional fixed income instruments, a covered call strategy can provide high net worth clients with a tax efficient enhanced income solution, without taking on additional risk.
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