Beyond the Bond: Alternative income strategies

by Wayne Ferbert on April 9th, 2013

We wrote in last week’s blog that our concern about interest rates leaves us pondering alternative income strategies. We want to avoid traditional fixed income because of the price risk when interest rates start to rise again. Goldman Sachs even put out a research piece in which they predict a half point rise in real interest rates by year end.
So, what are some alternatives that don’t carry the same long-term interest rate risks? Here is what we are looking at and using:
1.     Utilities
The utilities sector, of all of the sectors in the S&P500, has the lowest correlation to the broader market. It is still a group of stocks – but it doesn’t move lock-step with the index like many of the larger sectors.
The XLU (S&P utilities sector ETF) is the one we like to use. It offers a 4% dividend and it has options that trade on it if you’d like to purchase long term protection from a significant market event.
Utilities do carry some interest rate risk – but it is not very high and it is not correlated to the broader fixed income market. The only risk in utilities to interest rates is that utilities are often viewed as a substitute product for fixed income. So, as interest rates improve on new bond issuances, some of the utilities money might move naturally back in to fixed income. But that is a sea-trend change – not an overnight one. For now, we like utilities for a nice dividend yield.
2.     Selling covered calls

We have said for a while that we think the market looks fully valued. If we believe that, then we should be willing to sell covered calls with real conviction.
If you have a significant equity position(s), consider selling calls against it to generate some extra premium. The volatility of the stock should determine the returns you can create relative to the upside you need to give up. For the average stock, we look to generate around 4% in extra annual premium. For higher volatility stocks, we look for north of 6%. For lower volatility stocks, we look for just around 2%.
We like to ladder our covered calls – meaning if we had 900 shares of a stock, we might sell 3 contracts in the near month, 3 contracts in the expiration out 2 months, and the final 3 contracts in the expiration that is 3 months away. We would look to give the stock more room to run in the later months. And we would try to blend that rate we get back in premium to create the desired annual returns.
If you have an equity portfolio anyway, we recommend this approach. You might as well look to grab some extra premium.
3.     Our High Probability Credit Spreads

We write about them on this blog regularly. The strategy is not correlated to the fixed income market at all – and it is a one month strategy. Interest rate moves will tend to have little to no effect.
We sell deep-out-of-the-money options structured as a spread to traders that are speculating that the market will move in a violent swing in a short time frame: by the near month expiration.
Our latest trade in the HPCS is summarized here – and if you search this blog, you will find the history of that trade over the last 18 months.
Good luck looking for alternatives to fixed income – especially if you agree with the general market hypothesis that interest rates are due to rise.

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