With interest rates continuing to remain elevated, investors can once again generate significant income from their bond investments.
As interest rates start to level out and perhaps even decline soon, capital losses should hopefully be less of a risk than the last twelve months.
As sophisticated investors, we can generate increase the yield provided by bond ETFs through the use of options. The strategy is a known as a covered call which involves selling call options against a stock position.
Let’s use TLT as an example.
TLT Covered Call Example
When running the Covered Call Screener for TLT, we find the following results:
Let’s evaluate the first TLT covered call example. Buying 100 shares of TLT would cost $8,678. The November 17, $87 strike call option was trading yesterday for around $2.45, generating $245 in premium per contract for covered call sellers. Selling the call option generates an income of 2.91% in 38 days, equalling around 27.2% annualized. That assumes the stock stays exactly where it is. What if the stock rises above the strike price of $87?
If TLT closes above $87 on the expiration date, the shares will be called away at $87, leaving the trader with a total profit of $267 (gain on the shares plus the $245 option premium received). That equates to a 3.2% return, which is 30.4% on an annualized basis.
Let’s look at another example, this time using a further out-of-the-money call which provides less income but allows for more capital appreciation.
Instead of the November $87 call, let’s look at the $91 call. Selling the November $91 call option for $0.96 generates an income of 1.12%, in 38 days, equalling around 10.47% annualized. If TLT closes above $91 on the expiration date, the shares will be called away at $91, leaving the trader with a total profit of $518 (gain on the shares plus the $96 option premium received).
That equates to a 6.0% return, which is 58% on an annualized basis.
Of course, the risk with the trade is that the TLT might drop, which could wipe out any gains made from selling the call. Traders that think bond yields will continue to rise (and prices drop) would not enter this trade.
Barchart Technical Opinion
The Barchart Technical Opinion rating is a 100% Sell with a Strengthening short term outlook on maintaining the current direction.
Long term indicators fully support a continuation of the trend.
The market is approaching oversold territory. Be watchful of a trend reversal.
Implied volatility is at 22.38% compared to a 12-month low of 12.67% and a 12-month high of 29.76%.
The implied volatility rank is 56.82% and the IV percentile is 87%.
TLT currently yields around 3.69% annually.
Profile
The iShares 20 plus Year Treasury Bond ETF seeks to track the investment results of an index composed of U.S. Treasury bonds with remaining maturities greater than twenty years.
Bond investments are a common component of most investment portfolio, but they have suffered significant capital losses recently. Using covered calls can increase the yield component of your bond investments.
Please remember that options are risky, and investors can lose 100% of their investment. This article is for education purposes only and not a trade recommendation. Remember to always do your own due diligence and consult your financial advisor before making any investment decisions.
On the date of publication, Gavin McMaster did not have (either directly or indirectly) positions in any of the securities mentioned in this article. All information and data in this article is solely for informational purposes. For more information please view the Barchart Disclosure Policy here.
