A Preferred Share Alternative

Despite the lack of guarantees normally associated with fixed income securities, individual investors generally consider preferred shares a reasonable alternative to bonds. Probably the result of the favorable tax treatment that the Canadian government accrues to dividends.

To that latter point, the after tax return on dividends is enhanced by the federally sponsored dividend tax credit. Assuming you are in the highest marginal tax rate, a 4% dividend is equal to about 6% of interest income after tax. Of course it is unlikely that you can find a good quality mid-term bond that yields 6%. All the more reason to focus on good quality preferred shares not to mention some high quality blue chip common shares that yield close to 5% per annum.

For investors who like the dividend cash flow and stability of a good quality preferred share, the options market offers some interesting enhancements. I view the enhancements as a preferred share alternative.

With this strategy you buy common rather than preferred shares and write deep in-the-money calls. The sale of the in-the-money call reduces the out-of-pocket cost for the common shares, and by extension, enhances the dividend yield. In some cases to the tune of 7% per annum generated by a combination of dividends and capital gains. Seems almost too good to be true but as you can imagine there are caveats that should be understood before entering the strategy.

One caveat is understanding the pitfalls that can occur when writing deep in-the-money calls. For example, consider the common shares of BCE Inc. (ticker: BCE, Friday’s close $42.66) which pay an annual dividend of $2.11 per share which equates to a yield of 4.95%.

Investors seeking a high yield might buy the shares and write say, the January (2014) 32 calls at $10.40. Subtract that premium from the current price of the stock, and you out-of-pocket cost comes in at $32.26. In theory, the $2.11 annual dividend means that the revised position now yields 6.56% with minimal downside risk. Which is to say, BCE would have to decline below $32.26 before you would lose any money on the position.

However, you will not likely receive any dividends because the BCE January (2014) call has no time value. In fact the bid price – which is what you would likely receive for writing the calls – is trading 26 cents below its intrinsic value of $10.66 per share (i.e. $32 strike + $10.66 in-the-money intrinsic value = $42.66 which is the current price of BCE). In this hypothetical case, you would likely receive an assignment notice the day before the stock went ex-dividend.

Beyond the possibility of early assignment, there is also the risk that the common share dividend gets reduced or even eliminated. The preferred share dividend is fixed and management cannot reduce the payout, although it could eliminate a payment as long as it also eliminates dividends to the common shareholders.

If you are looking to create a preferred share alternative by writing calls against the common shares of a dividend paying company, make sure 1) you are buying a mature company with a long history of dividends and 2) there is time value in the option premium. The latter point should minimize the risk associated with early assignment.

A stock you might look at is Bank of Montreal (ticker: BMO Friday’s close $57.35). The common shares pay an annual dividend of $2.80 which at the current price provides a yield of 4.88%.

You could write the BMO January (2015) 50 calls at $9.40 (bid price) which includes $7.35 intrinsic value and $2.05 time value. The sale of the covered call reduces the cost base of the BMO shares to $47.95 and pushes the dividend yield to 5.84%. Of course you also earn the $2.05 time value (~ 7 cents per month) over the next 29 months (assuming the stock is not called earlier) effectively boosting the annual yield to 7.15%. That yield is a combination of capital gains and dividends.

The risk is that BMO declines below $50 per share by the January 2015 expiration. However this is an income generating strategy and as such, daily changes in the value of the underlying shares while important, should not dictate changes to the strategy during the 29 month holding period.

Another possibility is CIBC (ticker: CM, Friday’s close $73.24), which pays a $3.52 per annum dividend equating to a 4.81% yield. CM carries a little more risk, but you could consider a shorter term deep in-the-money covered call, say the January (2014) 64 call which was trading at $10.85. The CM January (2014) calls have $9.24 intrinsic value and $1.61 time value but only 17 months to expiry.

The sale of the January (2014) 64 reduces the cost of the CM shares to $62.39 which is the base price on which you would earn $3.52 in dividend income plus approximately $1.14 in time value accrual over the course of a year. The combination of dividends and time value accrual equates to an annual yield of 7.60%.