Cash-Covered Puts As A Bond Alternative
With the 10-Year Treasury yield still barely above 1%, and high-quality corporate bonds mostly below 2%, fixed income investors are understandably seeking alternatives.
There is of course the option to accept more risk and invest in junk bonds (or a junk bond fund). But that’s a pretty risky strategy for investors relying on interest payments for income. Junk bonds default, and the last thing a fixed-income investor wants is to lose their principal.
But there is a strategy that gives yields as good or better than junk bonds at far less risk. I am referring to the use of the cash-covered put. This was the strategy I explained in last week’s column detailing a low-risk trade based on GameStop’s (NYSE: GME) volatility. (That trade, incidentally, was up 30% in one week despite a sharp downward correction in GameStop’s price.)
Recall that an investor who buys a put is buying the right to sell their shares (in 100 increment lots per contract) at a defined price at which the trade would be executed (the strike price) and a defined date by which the trade would occur (the expiration date).
The person buying the put is either betting the price will go down, or they are buying insurance against shares they own just in case the price collapses. For example, someone who owns shares in a company trading at $150 a share might buy a put with a strike price of $120 to ensure they can still sell their shares at least at that price.
The person selling the put is creating the potential obligation to buy shares. If you sold the $120 put to the person above, and at expiration shares were trading at $80, then you still have to pay them $120 for their shares. That’s the risk involved, but you are being paid for taking that risk.
Of course all investing involves some degree of risk, but the key to this trade is in keeping the risks low. Let’s consider a couple of examples.
I’m Lovin’ It
McDonald’s (NYSE: MCD) is a Dividend Aristocrat that has increased its dividend for 45 consecutive years. It’s a stable business that is highly likely to continue paying its dividend, which currently yields 2.4%. So you could simply buy shares and reap the 2.4% dividend.
But there’s downside risk, which income-investors are generally seeking to minimize. The 1-year trading range of McDonald’s is $124.23 to $231.91. During last year’s pandemic-induced volatility, shares fell by 35% in just a couple of weeks.
With the cash-covered put, we want to limit that downside while generating reasonable income. This will involve a trade-off. For example, let’s say I want to earn 4% on my money. As I write this, there is a put with an expiration date of 01/21/2022 and a strike price of $170.00 with a premium of $6.90. If I sold this put I would create the obligation to buy 100 shares of McDonald’s for $170.00 per share if the price drops below that level by the expiration date. That would reflect a 20% discount to the most recent closing price of McDonald’s shares.
Since options trade in 100-share increments, I would need to set aside $17,000 in cash for this trade. That is the cash that I would have otherwise used to buy bonds. I would receive $690 for selling this put, for a return of ($690/$17,000), or 4.1%. My risk here is that I would be assigned shares at a 20% discount to the current price, and this is actually discounted by another 4.1% because of the premium I was paid.
If I want to accept a lower yield, I can further reduce my downside risk. For example, I can do the same trade above except with a strike price of $160 (6% less than the above example) and receive 3.1% in income on the cash I set aside.
How About Them Apples?
But you might find even better risk/reward profiles in higher-flying stocks. Consider Apple (NSDQ: AAPL). In the trade above with McDonald’s, you could receive 4.1% and only have to buy shares if they are down at least 20% a year from now. But Apple offers the same yield with 35% downside risk protection. In other words, Apple shares would have to decline by 35% before you risked assignment, while still collecting the 4.1% yield.
In both cases you got much better yields than from current bond offerings. You would just have to decide whether in the worst case you would prefer McDonald’s shares at a 20% discount from the current price, or Apple’s shares at a 35% discount.
If you don’t get assigned, and the lower you drop the strike price, the less likely that will be, you can turn around and sell another put. I should also point out that you can “double-dip” on your yields. The cash you set aside for these trades can simultaneously draw interest in your brokerage account. Granted, interest rates in money market accounts are pretty low right now, but that won’t always be the case.
Ultimately, there is some risk involved. You just have to decide if that risk is acceptable. In the case of a market correction, you may very well be assigned shares, albeit at a significant discount. But as long as you stick with quality companies, buying Apple at a 35% discount is a whole lot better than losing your principal because a junk bond defaulted.
Editor’s Note: The economy is improving, stocks are rallying, and the roll-out of vaccines provides hope that we’ll get the coronavirus pandemic under control. But we’re not out of the woods…not by a long shot.
Risks still lurk around the corner. More than ever, you need to be selective with your investments.
That’s why our investment team has put together a special report: “5 Red Hot Stocks to Own in 2021.” In this report, we provide the names and ticker symbols of the highest-quality stocks to own for the new year. Click here for your copy.