Investors have been “starved” for yield for years now and unfortunately interest rates aren’t going up anytime soon. When looking at individual bonds, investors get to choose between high quality bonds at paltry yields or junk-rated bonds that look attractive but come with a slew of bad risks that often aren’t understood or appropriate for retirees. Anything of decent quality and yield is instantly gobbled up. So, when the market doesn’t offer what you’re looking for, sometimes you just have to create it yourself!
Given how low yields are, stocks have been the only game in town for a few years now which is concerning because they’ve been pushed higher than they would have climbed without the Fed’s QE. Since I don’t see interest rates rising anytime soon, stocks will probably remain a primary investment vehicle so here’s how I’m using the stock market to create these “synthetic” bonds:
I find a high quality company that I would be willing to buy if the stock dropped. I use a combination of valuations and charting to identify the price at which I’d be willing to step in and buy the stock. I then do a buy/write trade where I buy the stock today but simultaneously “write” (which means sell) a covered call option with a strike price of my target entry price and an expiration date anywhere from 6 to 18 months from now. This replicates a short-term bond (hence the “synthetic” name) if the stock remains above the strike price. This is essentially the same structure as selling cash-secured put options, which I often do for short-term trades, but I reverse it with a buy/write for longer term trades so we can collect the stock dividend along the way.
Here’s an example to make this easier to understand. Please note – these numbers are rounded approximations for illustrative purposes only.
- Starbucks (SBUX) is trading around $55/share; I would be willing to buy Starbucks’ stock if it fell below $35/share which would require a 40% drop in the stock price
- Today I bought Starbucks at $54.63/share and simultaneously sold the Jan 2018 call option with a strike price of 35 for $20.63. This was a net cost of roughly $34/share (54.63 – 20.63 = 34).
- If SBUX is trading above $35/share on the expiration date in January 2018, the call option will be exercised and I will be forced to sell my stock at $35. With a net cost of $34, this would be a gain of roughly 2% (after transaction costs). However, since I own the stock I also collect the dividend each quarter which is currently $0.20/share per quarter. With 6 quarters of dividend payments between now and January 2018, that would be another $1.20 I earn for a total gain of roughly $2.10/share (after transaction costs) on a cost basis of $34/share. That’s a return of approximately 6.2% in 20 months, which is about 3.7% annualized. Is that a homerun? Absolutely not. But in this environment, a 3.7% yield isn’t too bad for a 20 month short-term “bond.”
As is common these days, you may be thinking: why don’t you just buy a stock with a 3.7% dividend yield. The reason is that I don’t want the price risk if the stock drops 10% or 20% (or more). I want a decent yield without stock market risk (i.e. a bond) so what I’m doing is using a stock and a stock option to replicate a bond. Where this could go wrong is if SBUX falls more than 40%, which is very possible. Then I have stock risk. But that’s fine because I said from the beginning that I would be willing to buy Starbucks’ stock at $35 if it fell that far, meaning I’m willing to accept the stock risk at that point. By the way, under $35, SBUX would have a dividend yield over 3.35%. Not too shabby for one of the best run companies in the world.
One last point: by selling a call option, I’m “short” the option which means that I could be forced to sell my shares of Starbucks at the strike price of $35. Basically the only time this would happen is right before a quarterly dividend payment. If it occurred, I would lose the shares and not collect the dividend, but the trade would be over and I would instantly realize the roughly 2% gain (the difference between entry cost of $34 and selling price of $35, minus transaction costs). Either way, whether the trade ends early or runs all the way through expiration, is fine with me.
I’ve created a few of these “synthetic” corporate bonds lately within our Income allocation in portfolios on companies like Starbucks, Amgen and Linear Technology. I’m targeting a few others as well.
When markets are difficult, sometimes you just have to get a little creative. Thanks for following!
-Nick