Using Options To Juice Your Fixed Income Returns

Interest Rates, Options, The Fed

The Federal Reserve’s ultra-low interest rate policy and quantitative easing programs are regularly debated among economists, armchair analysts, and everyone in between. Monetary policy can be pretty complex, with hundreds of variables to consider. So, it’s not a huge surprise that there’s so much disagreement on policy.

Most studies have shown that the Fed’s increasingly aggressive practices over the last decade have helped the economy. That is, they have kept the bottom from falling out in terms of economic growth. And, they have supported asset growth (real estate, stock prices, etc.)

Image of government bond heading for a definition.

On the other hand, ultra-low interest rates also mean tiny yields on most fixed-income products. For someone who relies on a fixed income payment (bonds, CDs, etc.), the last ten years have not been kind. Many fixed-income investors have had to look elsewhere for income-generating assets.

Investors have turned to the stock market for assets such as dividend stocks and preferred shares to find higher yields. What’s more, many investors have become interested in options trading to increase their yields.

One of the easiest and safest ways to juice returns on stocks is by using a covered call strategy. Covered calls consist of buying shares of a stock or ETF (in blocks of 100), while simultaneously selling calls against the shares. The calls can be sold at the price of the stock if the primary concern is yield. Or, they can be sold at a higher strike (price) to allow some upside appreciation.

The tradeoff with covered calls is they cap the upside potential of the underlying stock in exchange for a yield (return on cash at risk) for selling the call. Covered calls can be used on any stock or ETF, as long as it has options listed.

Here’s the thing: covered calls can be an ideal way to increase returns on fixed income assets without giving up the relative safety of bonds. For example, a covered call strategy can be used with iShares 7-10 Year Treasury Bond ETF (IEF).

IEF is a popular ETF for investing in medium-term bonds. The 10-year Treasury bond is an extremely important benchmark and is one of the most heavily traded instruments in the world. However, it pays a paltry 1.25% yield.

A covered call strategy on IEF allows an investor to substantially increase yields without giving up the safety of Treasury bonds. For instance, let’s say an investor thinks that IEF isn’t likely to remain above $118 per share. The 118 call option can then be sold as part of a covered call trade.

While buying the shares at $117.40, the December 118 calls can be sold for $1.75. That’s about five months until expiration, with a yield of 1.5%. Making this trade twice a year results in more than 3% annually in additional yield (on top of the standard dividend). This doesn’t include the additional 60 cents in potential upside appreciation in the share price.

With this strategy, an investor can earn more than 4% per year on a super-safe asset. That’s significantly better than just buying the bond (or bond ETF) by itself. Plus, it’s a simple trade to make.

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