The questions an investor should ask themselves are:
· What are the drivers of the income stream?
· How robust are these drivers of the income stream?
· How sustainable is the income stream over the long term?
Savers are being forced to seek alternatives to provide for income needs in a zero interest rate world. Many products are on offer and as in any reach for yield period investors need to be mindful of the risks they are taking on. One area of the market that may help in meeting income needs is the UK Equity Income Sector. An innovation in the sector is the use of a covered call strategy.
What are the drivers of income?
Stock dividends are the main source of income within equity income funds. However, an additional source of income that is worth exploring more closely is a covered call option strategy, one of the differentiating and advantageous tools used by a small number of income funds within the UK Equity Income Sector.
The strategy provides a fund with an edge over those reluctant to engage with options due to a lack of familiarity. While having a marginal influence on total returns, the strategy enables an investor to extract greater income from their investment so as to meet immediate income needs in a low investment yield world.
Like any equity fund the main drivers of returns are the stocks held in the portfolio and the ability of fund managers to pick the right stocks. The covered call strategy enhances the income above that received from stock dividends, for example taking a dividend yield of 5% to a fund yield of 7%.
How robust are these returns?
The robustness of the income stream from a fund employing a call overlay is dependent on the stability of stock dividends along with the ability to continue to implement the call overlay strategy. Stock dividends are dependent on the earnings of a company and on the ability of the company’s management to generate cash from those earnings. Within the RWC Enhanced Income Fund dividends are twice covered by free cash flow and therefore very dependable.
With respect to the covered call overlay the continued demand from banks to buy call options from funds such as RWC’s fund ensures that the fund yield can be enhanced above the dividend yield. The risks to such a strategy are predominately regulatory, such as an outright ban on short selling that would inhibit hedging by traders of the call option positions.
However, even in the middle of the UK banking crisis when short selling was banned on UK bank shares, the regulator allowed short selling when hedging positions such as those that RWC sell to investment banks.
Another attribute that ensures a market for call options, from a more risk aware banking sector, is the vanilla nature of such contracts as the risks are easy to manage and the fact that selling options to banks helps them to offset the protection positions that they in turn have sold to other investors.
How sustainable is the income stream over the long term?
Selling covered calls generates a premium for investors. This is paid to investors along with dividends to meet the target distribution. However, at the end of each contract there is the possibility that the option contract requires the fund to make a payment to an investment bank. This payment comes out of capital.
Therefore, what is important for the long-term sustainability of the income distribution, in absolute terms, is to recover from the reduction in the capital base. Here is where stock picking is of huge importance as the companies in which the fund invests are the capital growth engine and thus responsible for repairing capital erosion.
Likewise the amount of income withdrawn from such a fund is a key indicator to long-term sustainability. Income levels should be set against realistic long-term equity market returns. Extracting a level of income more than that will ensure the fund will, over time, wear down capital and witness the income stream reducing in absolute terms. To allow for a real increase in absolute income the distributed income should be 2% to 3% lower than expected long-term equity market returns.
There will be some volatility in the income distributions. Such funds are not delivering a coupon. However, it can grow the income unlike fixed income bonds. Furthermore, although a covered call overlay in the long run should deliver similar total returns it can outperform for prolonged periods in a low-growth, deleveraging environment. With no resolution to the Eurozone crisis in sight and the Eurozone and UK on the verge of a recession, 2012 looks like another year suited to a covered call strategy.
