June 12, 2018

There is a constant challenge for investors to generate a reliable income stream that accomplishes the goals of beating the rate of inflation, while not risking price erosion because of rising interest rates, and sporting a yield that greatly exceeds that of investment-grade bonds, CDs, Treasuries, and money markets.

One can delve into a number of rising-rate-resistant high-yield asset classes – such as convertible bonds, energy Master Limited Partnerships, private equity stocks, floating-rate business development companies, and aircraft leasing – but nothing works better for producing a robust stream of consistent absolute total yield than a well-managed covered call strategy (or ‘buy-write’ strategy, as some call it). They both mean the same: Buying common stocks and selling call options against the stock to generate immediate income.

Since NASDAQ broke out to new all-time highs last week, it behooves those who want to put to work a proactive covered-call strategy to have exposure to a heavy weighting in the sector that matters the most, namely Information Technology, while also seeking outsized yield. While a handful of mature big-cap tech stocks pay dividends with yields ranging from 1.5% to 2.5%, most technology stocks are owned for their growth prospects, not for their income. Still, they do offer some of the very best buy-write vehicles.

At the end of the first quarter, the outlook seemed best for the Financial sector, based on the widely-held view that bond yields from the 10-, 20- and 30-year Treasuries would widen out the persistently flat yield curve. That simply hasn’t happened and, for the most part, the mega-banks and regional bank stocks have lagged. At the same time, information technology and consumer discretionary have been trending higher:

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary

Investors looking to craft a dynamic covered-call portfolio should look no further than putting together a high-quality list of stocks that will get the job done. History is on the side of tech and consumer discretionary companies outperforming when interest rates begin to rise. Rising rates reflect a growing economy, with IT and consumer discretionary as two of the most leveraged sectors in a healthy economy, as evidenced by the strong sequential sales and earnings growth exhibited in the first quarter of this year.

Generating unconventional yield requires unconventional methods. When investing outside the bond market for high quality yields above 3%, this approach works. In applying a buy-write strategy, investors get their “cake” of being in the hottest sectors and “eating it too” by selling out-of-the-money call option premiums against the underlying portfolio, which can generate 6%+ extra yield per year.

One can stagger the call expirations so that monthly income becomes systematic. Buy the stocks, sell the calls, go to the beach, and pay for the vacation with passive call option income. Nice!

A Double Dose of Too-Big-to-Fail (TBTF) “Flies” in the Ointment

Even in a market landscape that is being described as “Goldilocks-like” from many well-respected market participants and fund managers, we always have to keep a keen eye open for negative developments that could escalate into a crisis that risks impacting the smooth path of the Goldilocks economy.

In the European landscape, I see (1) the Italian bond market and (2) the balance sheet of Deutsche Bank AG (DB) as two possible “flies in the ointment” of the global stock market rally.

(Please note: Bryan Perry does not currently hold a position in DB. Navellier & Associates does not currently own a position in DB for client portfolios).

Italy has managed to get through its election crisis by structuring a coalition government that will keep the country embedded in the euro currency. However, that does not change the composition of its publicly held debt, now at 160% of GDP, if Italy’s Target 2 liabilities to the European Central Bank (ECB) are factored in. This is Italy’s highest ratio of debt to GDP in 100 years. In addition, estimates of Italian banks’ non-performing loans amount to as much as 15% of their balance sheets. Italy’s bond market is the biggest in Europe and fourth largest globally. I expect a too-big-to-fail (TBTF) bailout plan to emerge at some point, since the ECB always seems willing to bail out its weakest members.

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

The other fly in the ointment is the future of Deutsche Bank short sellers, who are targeting Deutsche Bank after reports that U.S. regulators added the bank to its group of troubled lenders sent the stock to a record low on May 31. Bets against DB rose to 5.1% of outstanding shares on Thursday, the highest level since May 2017, according to IHS Markit data. AQR Capital Management increased its short position against DB to over $520 million last week, and hedge fund Marshall Wace has a $150 million position.

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

S&P reduced DB’s rating by one notch to BBB+, the third-lowest investment grade, citing “significant execution risk” after several management changes and strategy updates in the past years, saying repeated leadership changes pose questions over its long-term direction, against a background of chronically low profitability. Adding to the market concerns about DB is its exposure to derivatives, a large pool of hard-to-value assets that the bank holds, currently estimated at $47 trillion – yes, that’s trillion, with a “T.”

According to newly-appointed CEO Christian Sewing, the true net exposure to the bank’s balance sheet is around $41 billion. Most of Sewing’s banking career has been with Deutsche Bank, which makes a lot of analysts cautious, to say the least. Shares of DB are trading at 0.28 times book value when healthy banks usually trade at one to two times book value. The stock has shed 44% in the past four months and closed at $11.25 Friday, with the shorts still piling on despite shares’ new all-time lows in recent sessions.

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

Simply speaking, Deutsche Bank is too big to fail. Its tentacles are spread all over the world, with huge counter-party risk. If DB were to fail, JP Morgan would have serious problems of its own. It will take massive intervention by the German government and major central banks to infuse the level of liquidity necessary or, as some argue, nationalize the bank. The idea is not irrational. General Motors shares went to zero and wiped out shareholders in 2009, triggering a government (TBTF) takeover, and this may be where this story goes next. One thing I do know is that DB is one big whopping fly in a pool of ointment.

About The Author

Bryan Perry

Bryan Perry

Bryan Perry is a Senior Director with Navellier Private Client Group, advising and facilitating high net worth investors in the pursuit of their financial goals.

Bryan’s financial services career spanning the past three decades includes over 20 years of wealth management experience with Wall Street firms that include Bear Stearns, Lehman Brothers and Paine Webber, working with both retail and institutional clients. Bryan earned a B.A. in Political Science from Virginia Polytechnic Institute & State University and currently holds a Series 65 license. *All content of “Income Mail” represents the opinion of Bryan Perry*


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