The search for yield has been a long-term theme among
investors, for more than a decade. Interest rates have been microscopic ever
since the Great Recession, and many fixed income products have lost their
allure.
At first, asset classes like muni bonds and high yield
corporate debt became the go-to products for those looking for bond-like
returns with reasonable yields. But despite the occasional fair amount of risk
in credit markets (like in March of this year), even traditionally higher-yield
debt has barely paid enough interest to keep the lights on.
Last week, the Wall Street Journal featured an article
talking about the “variable denomination floating rate demand notes”
offered by some carmakers, which have become popular with investors. These
unsecured, callable, changeable rate notes are paid from the car companies’ cash
flow—typically 2-3% annually.
So the car company can call these notes (take them back)
whenever they want. They can change the rate on a whim. And they are unsecured
(no protection from a default). For all these great benefits (sarcasm
intended), investors get a whopping 2% return per year. Yay?
In my frank opinion, there are far better ways to generate
yield from car companies using options strategies such as covered calls. Yes,
covered calls are considerably closer to equity exposure rather than debt, but
with the type of risk people are taking for a 2% yield, I think it makes sense
to look elsewhere.
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For example, let’s look at a covered call that traded last
week in General Motors (GM) options.
A trader purchased 150,000 shares of GM for $44.04 and sold
the December 18 46 calls against those shares for $1.35 per contract. The call
sale brought in $202,500 in premium, which amounts to 3% in just 30 days. In
other words, annualized, this strategy would yield 36%.
With a covered call, the shares are purchased, which means
the position does have downside exposure to GM stock. However, the stock won’t
get called away if it finishes below the strike price (46 in this case). As
such, new calls can be sold each month against the shares while the stock
recovers.
What’s more, by using an out-of-the-money strike, the trader
is allowing for nearly $2 in stock appreciation for the next month. If GM is at
$46 or higher at December expiration, the position will generate $1.35 from the
call sale, plus $1.96 in stock appreciation. That works out to a 7.5% return in
just a month.
Whatever your opinion of GM, I’d much rather take a chance
to earn 7.5% in a month, with a guaranteed 3% payout at the very least, rather
than 2% for an entire year. Don’t forget that 2% (from the variable notes)
isn’t guaranteed and can change at any time. In the search for yield, taking on
a bit more equity risk can go a long way towards getting far superior returns.
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