Looking for a Bond Substitute?

Despite the hype around the Trump Rally, some stocks have been left behind. Notable among the group; BCE Inc. (TMX: symbol: BCE) which closed last Friday at $58.28. Well off the highs of August 2016 when the stock traded above $63 per share.

A growth investor might consider that tragic. However, most investors see this company as a blue-chip stalwart in the Canadian market. The company is rich in cash flow and has a management team intent on giving back to shareholders. BCE has increased its quarterly dividend 12 times since the financial crisis. The most recent bump being announced in January which will see the quarterly dividend rise to 71.75 cents per share payable in April.

Given the trajectory of the dividends you want consider using BCE as an alternative to bonds within your portfolio. A strategy that is not as far-fetched as you might think.

You may recall that prior to the financial crisis BCE was in play. The Ontario Teacher’s Pension Plan (OTPP) wanted to use the cash flow from continuing operations to fund a portion of their pension liabilities. Sounds a lot like a fixed income alternative! The deal fell apart when two hedge funds that were partnering with OTPP were caught with a flood of redemptions at the height of the financial crisis. In the end, they simply could not come up with their share of the capital to take BCE private.

But that was then and this is now! In the current environment, you could argue that what is bad for bonds is probably not good for BCE. All true to a point. However, with interest rates expected to rise, we know with certainty bonds will fall in price. Such is the teeter-totter effect where bond prices move inversely to the instruments fixed interest rate.

For BCE, the linkage between rising rates and a lower stock price is not as clear cut. For instance, the yield on BCE (4.92% given the most recent dividend increase) is well above the rate payable on ten year corporate bonds. Secondly, the variability in BCE’s cash flow gets reflected in management’s push to continually bump up the dividend, vastly different from the fixed interest payable on a bond. Third, what is underlying the higher interest rate scenario, is a normalization of the economy which means more growth and perhaps, higher inflation. Any run up in growth is positive form BCE and any increase in inflation while not a positive, is certainly not a major negative for the company.

What we have then, is a company that I believe could be used within a portfolio, as a bond proxy. Given historical trends where management tends to increase dividends each year, I would not suspect another increase this year. So, you might think about augmenting the cash flow from the quarterly dividend by selling covered calls on BCE.

Selling say, the BCE January 59 calls at $1.80 per share. Think of this as a fifth dividend which would provide some downside protection and add to the total return on the position. The yield to maturity – keeping with our bond alternative analogy – over the next 11 months is 8.01% assuming the stock remains where it is currently trading. If the stock is called away at $59 next January, the return gets bumped to 9.25%. As for the downside, the premium received reduces the downside risk to $56.48. Not bad for a bond substitute.