Tuesday, August 18, 1998
Options
A bond strategy alternative
By RICHARD CROFT
For the Financial Post
ÿHave you noticed the shift in assets over the past four weeks? The U.S.
30-year bond was yielding 5.55%, down from better than 6% a year ago and
the lowest level in 30 years. Some say yields will fall further.
ÿIn Canada, the 30-year bond is priced to yield about 5.7%, well off
from the highs of just a year ago.
ÿWhat we are seeing is a flight to quality from equity markets to
fixed-income markets. But the problem with this strategy is twofold.
ÿFirst, bond prices and yields are inverted. When yields are falling,
the price of the bond is rising. But at 5.7% in Canada, how much further
can yields fall? If the Bank of Canada has to raise interest rates to
defend the C$, bond prices will fall. Protection of principal was the
reason investors moved from equities into bonds in the first place, so
doesn't that scenario defeat the purpose?
ÿSecond, the 5.7% yield will hardly get you where you want to go long
term. At that rate, money doubles every 11 years, assuming you earn that
rate after tax. Outside a registered retirement savings plan, the asset
switch is more difficult to justify because half the interest income
will be lost to taxes. Owning bonds is not always the best alternative
to equities.
ÿFearful investors are left frustrated with few real long-term
alternatives to the equity markets, which is why I believe that this
bull market is far from over. That said, worried investors still need an
interim alternative to protect their assets from the volatility in
equity markets.
ÿWhich brings me to an option strategy that I think offers an
alternative to switching assets into bonds: selling covered calls on
bank shares.
ÿWhen you sell a call option, you are obligated to deliver the
underlying stock at a specific price for a predetermined time. That the
call option is "covered" simply means that you own the underlying stock.
ÿThis is an interesting alternative because bank stocks have been hard
hit on the heels of an earnings warning by Canadian Imperial Bank of
Commerce two weeks ago. All of the big five banks are off by between 20%
and 30% from their 52-week highs. The dividend yield alone is worth 2.5%
a year, which, after tax is about the same as 5.7% interest income from
the long bond.
ÿThe sale of a covered call generates incremental income. And because
the bank stocks have fallen so hard so fast, option premiums have
expanded. Higher volatility begets higher option premiums, which for
this strategy means more income from the sale of the covered call.
ÿAs a bond substitute, bank stocks make sense. Like bonds, bank stocks
react to the level of interest rates. Higher rates mean lower bond
prices; for banks, higher rates mean fewer loans, lower profits and
lower stock prices. Indeed, that was one of the most common comments
from analysts during the recent selloff of bank stocks: the Bank of
Canada may raise rates to defend the C$.
ÿBut when you look at the major Canadian banks, as much as half their
revenue comes from wealth management and service fees. Banks have
benefited over the past 10 years from diversifying their revenue stream
to avoid their dependence on interest rate fluctuations. So the question
is, has something fundamentally changed over the past three weeks?
ÿHowever, the issue is not whether banks are cheap or overpriced because
we are looking at the covered call strategy as an alternative to a bond.
If the scenario is "rates rise and bank stocks decline," how is that a
problem? Won't the price of the bond also decline if rates rise?
ÿAs an example of a fixed-income substitute, consider writing a covered
call on Bank of Nova Scotia (BNS/TSE), which recently traded at $31.50 a
share. Buy the stock and sell the January (2000) 35 calls. These call
options, referred to as LEAPs (long-term equity anticipation
securities), expire about 17 months from now, in January 2000. When you
sell these calls, you are obligated to deliver the BNS common shares to
the call buyer at $35 a share. This obligation ceases on the Saturday
following the third Friday in January 2000.
ÿWhy agree to sell the stock at a price just slightly above the current
price? The answer: this position is being structured as a bond
substitute. The objectives are income and preservation of capital. We
are not concerned about upside potential, merely about how much income
we can derive from the position over the next 17 months.
ÿWhen you sell the option, you receive a fee, referred to as the
option's premium. The premium received from the sale of the BNS January
(2000) 35 call is $3.80 a share -- immediate income that you keep no
matter what happens to the stock between now and January 2000. That
premium is taxed as a capital gain, which is less than the tax on
interest income. And you do not need to declare the income until the
option position is actually closed out, which can go to January 2000.
ÿLet's add up the potential income. You immediately receive $3.80 a
share from the sale of the option. Over the next 17 months, because you
own the stock, you will receive quarterly dividends paid by Bank of Nova
Scotia. That comes to six dividends totalling $1.20 a share. Total
income comes to $5 a share on a $31.50-a-share total investment.
ÿOver the next 17 months, three things can happen: BNS can rise, fall or
stay the same. If BNS rises above the strike price of the call, the
option will be exercised and the stock will be called away. You simply
deliver the BNS shares and receive the $35-a-share price originally
agreed upon. If the stock is called away, the return will be 30.6% over
17 months, or 21.6% compounded annually.
ÿIf the stock remains the same, your return is 24.2% over 17 months, or
17.1% compounded annually.
ÿIf the stock declines, you will retain the stock and the income, just
as you would if the bond fell in price. Of course, with a bond, your
principal investment is guaranteed at some point in the future. (I
believe, in terms of volatility, that using a bank stock to cover a
short at-the-money call carries about the same risk as a bond portfolio
with a 10-year term.)
ÿThe question is whether the potential income from this strategy -- the
income over 17 months is 9% higher than the yield on the 10-year
government of Canada bonds -- offsets the risk that the stock could
decline. There is no definitive answer because risk-return tradeoffs are
such personal matters.
ÿOne thing is certain, selling covered calls against bank stocks carries
much less risk than holding an all-equity portfolio without a hedge.
ÿ
Richard Croft is president of Croft Financial Group, a Toronto-based
investment counselling firm.
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