The Problem With Covered Call Writing

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From a long-term perspective, we think that interest rates and inflation over the next 5, 10 years or more are probably going to be higher than they've been over the past 10 or 20 years. And that means that the returns you would expect from those long-term or even medium-term Treasury obligations are probably going to be worse than they've been over the past 10 or 20 years.

Hello and welcome to the Barron Streetwise Podcast. I'm Jack Howe, and the voice you just heard, that's Jared Woodard.

He's head of the Research Investment Committee at Bank of America Securities, and he's going to talk with us today about, gosh, lots.

Imprudent yield. What is imprudent yield and where should you not go to find it? And what is prudent yield? Where should you be looking for yield? And what are the charms of CLOs, collateralized loan obligations? Hear us out.

Isn't that what caused the 2008 financial—

No, no, don't. No, don't say it. Close, but no.

We'll talk about it. And covered call writing. There's a problem with it. We'll cover that too.

Listening in is our audio producer, Jackson. Hi, Jackson.

Hi, Jack.

Go ahead. You were saying?

Isn't collateralized CDOs, CLOs collateralized loan obligations?

You were about to say—

There's a Big Short about this.

Aren't they what triggered the global financial crisis?

There's a difference, and it sounds subtle, but it's actually pretty significant. Collateralized mortgage obligations are backed by pools of mortgages, and mortgages are a pretty specific thing. So if the housing market suffers, let's say, a severe price decline, which is unusual historically speaking, but it has happened, that could spell trouble for CMOs altogether. Collateralized loan obligations, on the other hand, Those are backed by loans made to companies, all different types of companies. So they allow for greater diversification. And in a moment, Jared's going to explain why the risk profile on CLOs in his view is attractive now. That's one thing I wanted to pre-explain just before we let our conversation with Jared run. The other thing is covered call writing. Calls are a type of option. Options are bets placed on the direction of stocks, specific bets. I think this stock is going to go up this much before this date. People use options because they can get a lot of bang for their buck by placing such specific bets. They can put relatively small dollar amounts at risk for big payoffs. But just as in a casino, there are the people placing the bets and there's the house, which is in the business of selling the bets, and the house is not a big risk taker. The house likes to make steady, dependable money. In the options world, people who write covered calls, they play the part of the house. They're saying, I own these blue chip stocks, and if you want to make a bet on them, I'll sell you that bet. And if the bet doesn't pay off, well, I'll have collected the price of the bet, the bet will expire worthless, and I'll be free to do the whole thing again. So covered call writing is a relatively conservative strategy for generating extra income on a stock portfolio.. And some people love it. And Jared says it's not a great time for it now. We'll hear more about that. Jackson, anything else that I need to pre-explain before we get going with the call?

Why do different countries use different plugs for their electrical?

Revenue raiser. There's a central group that's in charge of scamming people on adapter revenue.

Next. Why are North Dakota and South Dakota separate states?

South Dakota didn't want to share its Mount Rushmore tourism revenue.

I actually saw a survey that ranked Mount Rushmore as the most overrated tourist attraction in the US.

Outrageous. That's an outrage.

I will not stand by idly.

What was number 2? What was the second worst?

Plymouth Rock. Well, that's fair. Timeout says it's liable to leave you feeling underwhelmed and scratching your head as to the appeal of the site.

When did this turn into a national monument roast? Let's get to my call with Jared.

What is imprudent yield and who's reaching for it?

We write a lot about what we call prudent yield, which means when you're getting paid adequately for the risk that you're taking. And what we are calling imprudent yield are those parts of the market right now, we're talking mostly about fixed income where you're taking some really concentrated risk,, but not really in our view getting paid enough for it. And the two key examples of this are in so-called high-quality fixed income, treasury bonds, investment-grade corporate bonds. You're taking on a lot of risk in the form of, you know, higher inflation interest rates, which people ignored for a really long time for fair reasons, and then was brought sharply to mind in 2022. And again, this year treasuries are down meaningfully. They're on pace to endure another bear market.

This is a little different from what I hear from some folks. I hear some people saying, "Hey, yields are a lot higher than they were just recently, and this is an opportunity, and you know, maybe they'll cut interest rates soon, and maybe this opportunity will disappear, so you should lock in yields while you can." And they say, you know, stick with quality stuff, but you don't see that as a good deal.

It's if you wanna make the tactical trade to say, okay, you know, 10-year Treasury yield is at 4.6% and maybe it goes down to 4.2% and that type of thing. Great, that's fine. But for a long-term investor who's thinking about big chunks of their portfolio and how they ought to be allocated, the, the view from Bank of America is that from a long-term perspective, we think that interest rates and inflation over the next 5, 10 years or more are probably going to be higher than they've been over the past 10 or 20 years. And that means that the returns you would expect from those long-term or even medium-term Treasury obligations are probably going to be worse than they've been over the past 10 or 20 years. By the way, investment-grade corporate bonds are even possibly a worse bet because right now the spread, meaning the difference between the yield on investment-grade corporates and the yield on Treasuries, is near some of its narrowest, smallest levels ever, which means that, again, if you see adverse conditions in the economy or you see higher inflation and interest rates or, or both in a stagflationary scenario, then you're getting less compensation than ever before to bear that risk in the investment-grade corporate bond market. So to us, yeah, there's some high levels of yield, but it's not very prudent. The risk isn't worth the reward. And at the other extreme, this isn't just about knocking on conventional wisdom about quality, but we looked at the returns to the very riskiest parts of the corporate bond market. So CCC-rated high-yield corporate bonds. And historically, going back decades, the data suggests that the difference between what those bonds' face value yield is versus what you actually realize as a total return as an investor is such a wide gap because of the higher default rates that in fact that, that middle of the pack in terms of credit rating has given you better returns and better risk-adjusted returns on just about any timeframe than buying the riskiest, highest-yielding parts of the corporate bond market. So, so the point here is Either extreme to us looks like a bad deal. I mean, Aristotle said virtue is the mean between two vices, and we see today investors indulging in vices of extreme exposure at both ends of the spectrum when really there's, I think, a virtuous mean in the middle, and that's what we try to write about.

Okay.

So is this a matter of, as you say, just looking for bonds that are between those two extremes? Are there other types of assets? Types of income investments that are more attractive? Where should folks go in this environment?

Well, we wrote recently about a few other parts of the market we think are worth some thought. Still within, you know, broadly still within fixed income and credit, the popularity of private credit these days is unprecedented. We think that there's better ways to invest in the same pool of underlying assets that a private credit fund would invest in without some of the attendant risks.

Private credit—

this is people who are—

if you're buying private equity, you're buying an ownership stake that's not traded like a stock is traded. And if you're buying private credit, you're buying a loan that is not traded like a bond is traded. These are typically for, for, would you say, more affluent investors that are putting money in private credit. This is sort of an alternative, uh, investment where, where people are seeking better risk-adjusted returns. But you say the deal there isn't good.

You got it exactly right. These are loans made to companies that for whatever reason, maybe they're too small, maybe they're too risky, you know, don't have access to the bond market. Making loans to companies obviously has been around for a very long time. That's what banks do because of regulation and other things after 2008, both the ability and the willingness of, of, of many banks to lend the way that they used to was constrained. And that created a market opportunity because it's mostly that regulation for for non-bank lenders to step in, often lending at higher yields for the same loan. But private borrowers have been happy to participate, and investors have been happy to snap those up. Our thesis is that, well, number one, we like investing in diversified pools of loans because anytime you're investing in the real economy with your eyes wide open about the relevant risks, especially if you have good transparency, you can do well. However, the kind of vehicle that you choose to invest in pools of loans is really important. And just like in the equity market, we think that liquidity and transparency and good governance is important. I think that's still true in credit. Right now you can invest in products called collateralized loan obligations, and there's now ETFs available for those that are very liquid, gathered a lot of assets that offer, in our view, the transparency The liquidity, lower fees, better efficiency for access to the same underlying market of loans that private credit funds are also offering. We think it's a better deal.

These are CLOs, collateralized loan obligations, that as you say, you could buy them like you would a stock if you buy them through an ETF. I mentioned this idea of yours about CLOs to someone and they said, "Wasn't that the thing that blew up during the housing bubble?" I said, "No, that's collateralized mortgage obligations. These are a different thing, right? These are, I mean, how would you, how would you compare CLOs? How would you describe these to someone who has not invested in them before?

They are a different thing. And anytime people come at you with 3-letter acronyms, it's wise to, to ask those questions. The, here's the big difference. In the run-up to the financial crisis, folks were extremely concentrated. Yeah. In mortgages. They were also structuring derivatives on those pools of mortgages with incredible amounts of leverage. The difference with collateralized loan obligations is that they're diversified across the whole economy. So the average, I think the maximum sector exposure in the average pool of these loans that we've looked at is on the order of 10 to 12%. Private credit funds, by the way, can run concentrations much higher than that, often to software or other cyclical sectors. But collateralized loan obligations have one other crucial difference and advantage in my mind, which is that the process of securitization of, of dividing up these pools of loans into what they call tranches and then relying on credit ratings to differentiate what kind of exposure an investor is going to have allows, again, that same underlying pool of loans to smaller and or riskier companies to provide investors the ability to choose what level of risk they want to take. You remember probably from, again, from, you know, 10, 15 years ago, diagrams of of like a champagne bottle spraying, you know, champagne. And then there'd be the, the tower of glasses built kind of like a triangle. And the similar concept applies here as in other parts of securitization that when you're a buyer of the highest rated tranche, the highest protected tranche of securities, AAA rated, you're going to get paid first to the extent that there's, you know, coupon payments and loan repayments left over. The next tier will get paid and so on down to the lowest rated and then even to the unrated so-called equity tranche. Well, look, the equity tranche is extremely risky. These are loans that may or may not get paid back. They have default rates that are a little bit higher than in the corporate bond market sometimes. But hedge funds and other folks participating in the market are happy to trade and be active in those very low-rated parts of the market. From our perspective, investors looking at AAA-rated and AA-rated tranches of collateralized loan obligations, we know from the historical data, you've never seen a default you never seen a dollar loss from a default in those high-rated tranches.

AAA-rated, you know, the, the safest rating for bonds. So, so, um, I mean, that would be something that you would compare to a, to a Treasury or some kind of pristine bond. Um, that you say in your report, a 0% default rate. You, you've, you've never seen a default there.

Even the Treasury, even, even the Treasury market, Jack, doesn't have a, a AAA rating anymore.

I forget sometimes. But you mentioned here BB CLOs. What's the significance there of the BB market? How would you characterize the risk and the return of that market?

If you want minimal risk and are willing to accept lower yield for that, you look for AAA. If on the other hand, you're a buy-and-hold risk-tolerant investor and you want higher level of yield with incrementally higher level of risk, or at least volatility month to month, year to year, then you can look lower. You can look at that. Had BBB, BB, single B areas. And there are some ETFs for that as well that track that part of the market. And so that's my point, is that if you're investing in credit, whatever your perspective is, minimal risk or more risk tolerant, do you want less yield or looking for more yield? The ability to choose and dial up or dial down the level of risk that you're prepared to take is a feature that's not available in other parts of this market that invests in loans to these companies. And so we think that whether it's the securitization that gives you that risk control, the greater liquidity. Remember, bank-syndicated loans, the part that are traded in these, these CLO products are pretty actively traded. There's, there's a lot of liquidity in this market now. That's not true in privately held, you know, loans from private lenders. So there's greater liquidity, greater transparency, securitization and risk control and lower fees that we think makes these a pretty compelling alternative to the alternative.

You point out here the double B CLOs have returned 12% a year since 2007, and that that's better than the return people have gotten on the S&P 500. But I mean, this is an asset class that, you know, if it's double-B rated, then yes, it's riskier than the highest quality part of this market. But it is— how would you characterize the risk relative to stocks? Isn't this a safer or less volatile asset class than stocks, or how does it compare?

These loans, they're called senior loans because they're senior in the capital structure of a company. So when a company's got— if it gets into trouble and it has to choose among its different obligations, these loans get paid first. When you're an equity owner in a company, you get paid last. You get paid last. You get paid obviously whatever cash flows are left over once everyone else has been taken care of. So the idea here is that from a capital structure perspective, these loans are are at the top of the stack. Now, as I said, I'm keen to emphasize these are companies that are not issuing securities in the bond market for a reason. Again, either they're too small or they're too risky or there's some other constraint that means that they're tapping this loan market instead of the regular corporate bond market. One other thing we haven't mentioned, Jack, that I should be keen to point out, big difference between bonds which are issued at a fixed rate these loans have floating rates. So for example, in 2022, when treasuries were selling off, when investment-grade corporates were selling off, as interest rates, inflation were kind of decimating markets, these floating rate loans and any other floating obligation really shined because those rates reset typically quarterly. And that gives, from an investor's perspective, it's a wonderful way to still be active in fixed income, to still earn a yield, but without having exposure to the threat of higher interest rates, you know, hurting your portfolio.

Big feature. Let me interrupt here quickly. We've been hearing about ways to seek out prudent yield, where to go and not go for yield. We've heard about why CLOs might be something you want to take a look at if you're so inclined, if they're appropriate for you. You know me, I wouldn't say CLOs are beyond my risk tolerance, but they might be beyond my fanciness tolerance, but they might be attractive here, as Jared says. And if you're interested, you can check out some ETFs. I'm looking at one from Invesco. The ticker there is I-C-L-O. There's a VanEck one, it's C-L-O-I. There's a BlackRock one, it's C-L-O-A. Are they expensive, Jackson? What do they cost? Give me— throw some expense ratios at me. I'm not going to pay a lot. For this CLO ETF?

All right, we got 0.2% on one end, and then—

what, 0.2%? What am I made of, money over here? Okay, 0.2%. Okay, I can live with that.

What else do you see? And some of them are 0.5%.

Come on, let's not get ridiculous. Okay, we're gonna take a quick break, and after the break, Jared has some thoughts for anyone who writes covered call options on their stock portfolio or is thinking about getting in on the game. That's after this quick break.

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Welcome back. We've been speaking with Jared Woodard. He's head of the research investment committee at Bank of America Securities, and he's been talking about yield, where to find it. Let's listen in on the rest of that conversation. I'm going to listen in on myself like a, Self-eavesdropper. I'll never hear myself coming. I want to ask you about covered call writing. This is an option strategy, and this is not a strategy for the, for the big risk takers, the gamblers. This is for someone who has a portfolio of stocks. They want to generate a little income on their stocks, so they're selling off these bets on their stocks to other people who are the gamblers, and they can generate some extra portfolio income. And I know some folks who've done it and they swear by it and they love it and they say, why wouldn't you do it? I make extra money. But, but in your report here, you say that this is the worst environment for call writing on record. How do you tell a thing like that? And what do you mean by that?

Two problems with many of the call writing strategies that are so popular today. Number one is that the premium that you get is, is very low. And if you think of it kind of like insurance, if you're an insurance company and you can take on risk, you can write policies for whatever things that you want to write policies on. Your goal as an insurance company is to get the most premium that you can on that policy to protect you in the case that you do have to pay out on losses. When you write, when you sell options, that's kind of what you're doing. So if the premiums you get are extremely low and then something unforeseen happens, in the case of these covered call sellers, the big unforeseen thing would be a move either way. Obviously, if stocks decline, the low level of premium isn't going to buffer the decline in your portfolio very much. But look, if stocks rally sharply, that's a problem too, because that means that you're, you're going to miss out on all that upside from a rally in the stock market more quickly than you would have if, you know, your premium was, was, was juicier. So that's a big problem. And the other problem is that stocks have been rallying. I mean, they've been, especially last year with, you know, a good start to this year. I think that the puzzling thing is that historically when these premiums are low, you know, you've seen massive inflows to products that are pursuing the strategy, particularly ETF. By our count, something like $70 billion of assets into these funds. And as you say, this isn't the riskiest of all strategies or anything like that. It's been around a very long time. I mean, in another life, I was a derivatives trader myself. Nothing wrong with using the options market to augment your return or risk profile in different ways. This just seems like a particularly inopportune, as I say, imprudent time to look for yield in this regard.

You're not being paid enough perhaps because there are so many other big-dollar investors now doing the same things, these funds, funds where people, you know, where they pursue covered call writing strategies. Is that the idea?

Yeah, you're not— for whatever reason, and we don't speculate on the cause, the price in the marketplace is again, isn't worth the risk. If you want income from the equity market, you know what's beat covered calls? Our old friend dividends. And you know what's beat dividends hand over fist is our old friend buybacks, which have really trounced the other two. In our latest update on these factors in the ETF market, we found that companies buying back their shares have really dominated every other version, whether it's high dividend or dividend growth. We suggest investors look for, you know, at least a blend of the two, if not just an outright buyback strategy. And those are liquid, easy ways to benefit from the return of capital to investors, this time from companies rather than from the options market, but without having to take risk at unusually historically low levels.

These are interesting ideas. Thanks for sharing them with me. Is there anything here anything that I'm missing, things that you've been telling investors, something I haven't asked you about, something that you think folks are getting wrong or that an opportunity they should know about right now?

Well, one last thing, Jack. We talked a bit about Treasuries before. You know, there's that old adage that you don't fight the Fed. Right now, at least in terms of their flows, we see investors, household investors, aggressively fighting the Fed. We know that the Federal Reserve is selling Treasuries and we look at Well, not just the Fed, but central banks around the world. They've been massively buying gold over the past 2 years at a clip you've never seen before. Uh, in fact, a lot of the conventional models to try to predict or analyze the gold price have broken down over the past 2 years. We had the idea a month or two ago, let's plug in those central bank purchases into a conventional model of the gold price, and lo and behold, it basically totally closes the gap, the explanatory gap between your normal model and the price today. All that to say, central banks are buying gold, the Fed's selling treasuries, and yet what do we see from household investors? They've been massive buyers of Treasury and Treasury ETFs and massive sellers actually of gold, even despite this rally. Pretty unusual to see that kind of disparity.

You think people who are selling gold, maybe they're like taking a profit because the price of gold has been running up. You think that's a mistake? You think people should be buying gold or—

Yeah, I think most investors haven't participated in this most recent rally. By our count. And we think there's a place to own gold in a portfolio because it is one of the least correlated assets to equities and other conventional asset allocation pieces. You can't print more of it as the, you know, kind of somewhat vulgar saying goes. But it is robust in that regard. And when you have central banks around the world, it's a diverse group too. It's not just like Russia or China or somebody participating in that market. I think investors should sit up and take a little notice.

Thank you, Jared. And thank all of you for listening. Jackson Cantrell is our producer. Jackson, go ahead and put the call out for some listener questions. Let them, let them know how you feel. Pull, pull on their heartstrings a little bit.

If you have been mulling over any sort of financial-related question, You said mulling or mowing?

Mulling.

That makes more sense.

Go ahead. Mulling it over. Just go and send those questions. Record them as a voice memo so we can hear your voice on the podcast and send them to jack.how. That's at barons.com.

As a voice memo, record them as a voice memo on what, on my shoe?

Yeah, if you have an iPhone. On the family tree? If you have an iPhone. I think there's also an Android version of a recorder app. Sorry, Android people, for ignoring you for the past, uh, 200 episodes here.

I need everything spelled out. Like Jackson says, go ahead and send us in your questions, and thanks a lot for listening, and we'll see you next week.

Data is everywhere. When orchestrated properly, it sings. At Morningstar, we analyze and enrich data making it actionable and powerful for you. Morningstar, where data speaks.