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Strategies for Income Investors seeking Yield

Richard Croft
April 27, 2015
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Income hungry investors continue to ramp up their risk appetite in order to collect extra basis points in yield. Bonds continue to defy gravity as foreign investors flock to the safety and higher yield in North American fixed income assets. Canadian bonds have turned in strong returns as witnessed by the iShares Broad Bond Universe (XBB) up better than 4% since the beginning of the year. There may even be more to come with sovereign debt issued by stronger European economies having slipped in negative territory. While it is difficult to imagine holding a security that guarantees to return you less money than you started with, these buyers believe the currency in which the sovereign debt is denominated will be stronger, which will more than make up for the negative yield. They may be right! With odds that Greece will exit the Eurozone and default on its obligations, there will be disruption in the Euro, which will inspire a flight to safety into stronger Eurozone partners and safe harbors like Canada and the US. The end result for Canadian investors; lower yields and higher prices for fixed income assets. The challenge for income seeking investors is that a higher price for fixed income assets means that the yield on these instruments will decline. And that does not take into account the punitive tax consequences for collecting interest income. Another approach is to look for equities that pay regular dividends. Dividends from preferred shares remain attractive although the value of many preferreds has not produced the kind of upside that we have seen with bonds. Most likely, because preferred shares are income producing equities where a missed dividend payment does not impact the corporations’ viability. A missed interest payment will force a company into bankruptcy. One preferred that I like is the Premium Income Preferred “A” (PIC.PR.A). This is a split share in a basket of major Canadian banks. The corporation buys a basket of Canadian banks and splits the potential growth (i.e. the capital share which owns the growth and dividend increases associated with the basket of banks) and an income stream (i.e. the preferred share which owns the preferential rights to the dividend stream paid by the bank basket). Think of the split shares this way; the capital share is a long term call option on the basket of banks while the preferred share is similar to a long term in-the-money covered call on the underlying banks. PIC.PR.A closed Friday at $15.36 and pays a quarterly dividend of .216 cents per share equal to a 5.63% yield. Since the underlying banks would have to fall precipitously for the in-the-money call to unravel, the yield is pretty safe. Keeping with that theme, you could implement a similar strategy by executing a longer term at-the-money call on a high quality dividend paying stock. Take BCE Inc. (BCE) as a case study. BCE pays a quarterly dividend of 65 cents per share which at current prices yields 4.82%. If you were to buy the shares at say $54.00 (Friday’s close $53.97) or better and write the January 54 calls, you would receive a premium of $2.15. For an income investor, this has appeal because the premium from the call option is taxed as a capital gain while the dividends receive preferential tax treatment via the dividend tax credit. The yield on this BCE covered call is 7.59% (annualized yield 10.30%) between now and the third week of January when the stock will most likely be called away. There is one caveat in that the BCE shares could be called away prior to the January expiration. That happens occasionally when selling in-the-money covered calls on stocks that pay above average dividends. However in this case that would simply mean that you earned your maximum profit early and could then enter a new in-the-money covered call using a longer term option.

Richard Croft
Richard Croft http://www.croftgroup.com/

President, CIO & Portfolio Manager

Croft Financial Group

Richard Croft has been in the securities business since 1975. Since February 1993, Mr. Croft has been licensed as an investment counselor/portfolio manager, operating under the corporate name R. N. Croft Financial Group Inc. Richard has written extensively on utilizing individual stocks, mutual funds and exchangetraded funds within a portfolio model. His work includes nine books and thousands of articles and commentaries for Canada’s largest media channels. In 1998, Richard co‐developed three FPX Indexes geared to average Canadian investors for the National Post. In 2004, he extended that concept to include three RealWorld portfolio indexes, which demonstrate the performance of the FPX portfolio indexes adjusted for real-world costs. He also developed two option writing indexes for the Montreal Exchange, and developed the FundLine methodology, which is a graphic interpretation of portfolio diversification. Richard has also developed a Manager Value Added Index for rating the performance of fund managers on a risk adjusted basis relative to a benchmark. And In 1999, he co-developed a portfolio management system for Charles Schwab Canada. As global portfolio manager who focuses on risk-adjusted performance. Richard believes that performance is not just about return, it is about how that return was achieved.

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