SVOL - XYLD: What The Declining Dividends Mean For Investors

2023-05-27 00:12:06 ET

Summary

• XYLD recently saw its dividend get reduced.
• The fund's forward yield drops from 12% to 8%.
• Investors shouldn't be worried but prepared. We also offer one possible fund to boost your income when volatility is dropping.

Global X Funds Global X S&P 500 Covered Call ETF (XYLD) is one of the most popular covered call ETFs and it enjoyed a high yield of 12% last year which attracted a lot of people to the fund. As a result of this increased attention from yield-seekers, the fund's AUM (assets under management) rose 72% in the last year even though fund's NAV was down -8%. However, the fund's high dividend yield might drop significantly starting this month. As a matter of fact, this month's upcoming dividend payment is announced to be 25% lower than last month's dividend and down 37% from last May's dividend payment.

This upcoming month, XYLD will pay a dividend of 28 cents per share, down from 38 cents per share last month and 44 cents per share in May of 2022. This gives us an annualized yield of 8.3% down significantly from 12% a few months ago. The graph below shows the monthly dividend history for XYLD and we can see that it's been on a downtrend since peaking March of 2022 at 50 cents per share. You might be wondering if investors should be worried and what this means for investors moving forward.

XYLD has a dividend policy (see slide 8) of paying 1% of its NAV or half of the premium income it generates from its covered calls (whichever is lower). This means that if the fund generates an amount that is at least 2% of its NAV on covered calls in a month, it will pay 1% of its NAV and if it generates an amount that is less than 2% of its NAV, it will pay half of whatever amount it generates.

For example, currently XYLD's NAV is $40.34 per share which is within 2 cents of the share price as of writing time of this article. This means 1% of XYLD's NAV is roughly 40 cents which is where the monthly dividend is capped no matter how much XYLD can generate from its covered call premiums. This is the upside cap and there is also the downside cap which is 50% of the premiums generated. If XYLD can generate 80 cents or more from its call premiums it will pay 40 cents at most. If the fund generates less than that, it will pay less. For example, last month it was able to generate 56 cents per share which means it will pay 28 cents per share in dividends. What happens to the rest of the premium generated? It goes back to NAV in order to support the share price.

In a perfect world XYLD would generate 3% yield per month from covered calls, give 1% of it in dividends and reinvest the remaining money back in the fund which would mean NAV appreciating 2% per month. It would result in 12% dividend and 24% share price appreciation for the fund which would give you 36% in total returns but we don't live in a perfect world. Typically, the fund pays up to 1% per month in dividends and the remaining money goes into NAV to keep it from eroding. If the fund can keep its NAV stable (let alone rising), it is a win for the fund.

How can we tell how much premium the fund will generate this month from premiums? It's actually easy to tell. The fund sells "at the money" covered calls one month out against its all of position (100% coverage rate). At the money means whatever the price was on the day the option was sold. For example right now SPY's price is $414.70 so if the fund were to sell covered calls today, they would sell them at a strike price of $415 expiring one month from today (around June 25th). Let's check the option prices for this specific instance. We are seeing an option premium of $7.10-7.21. Let's take mid-point of these two and we are getting a price of $7.16.

Collecting a premium of $7.16 on SPY's $415 corresponds to a return of 1.72%. Since the fund pays 50% of its premium (capped at 1%), its dividend payment would come at 0.80% (0.86 minus 0.06 for expense ratio) for the next month which would be 32 cents per share. Of course this is hypothetical assuming that the fund is selling calls today. Numbers might be slightly different depending on what day they sell the option on.

So what is causing all these fluctuations where fund's yield varies from 8% to 12% when the market isn't very volatile? It's something called VIX also known as S&P 500 volatility index. VIX is calculated by IV (implied volatility) value of S&P 500 options one month out (coincidentally this fund also sells S&P 500 options one month out). The more volatility there is, the higher VIX will be and the more option premium a fund will be able to collect. Notice in the graph below how VIX climbed to +75 at one point during the COVID crash. Last year was a highly volatile year for the markets but VIX generally ranged from 25 to 35, not rising to extreme levels but not falling much either. This helped covered call funds generate healthy levels of premiums from those call options they sold which helped them cushion last year's crash and many of them were able beat market returns as a result of this. Currently VIX is below 20 which puts it in the lower range of the last 3 years but there were also instances (pre-COVID) where VIX dropped to as low as 10. It was typically very low in 2017 and 2019 where option premiums were almost non-existent.

Now VIX is coming down and option premiums are dropping significantly. There are a few reasons for VIX coming down. One of these reasons is recent introduction of 0-day options. Now traders are able to buy daily options instead of weekly which takes away demand from monthly options. When there are less buyers for monthly options, their premium price drops. Second, there is less fear overall in the market. Last year when the markets were crashing people bought put options to protect their portfolios (also known as protective puts) which increased IV of both puts and calls. This year we are seeing less of this. Third, market has been stuck in a 3900-4200 range since November and when markets are in a range, people are less likely to pay premium prices for options because the pay-off won't be worth it.

Those investors holding XYLD and worried about declining income can buy Simplify Volatility Premium ETF ( SVOL ). This is another option premium ETF but it generally shorts VIX which means when VIX drops, it makes more money. Similar to XYLD, it pays its gains as dividend and currently yields 17%. Investors can hedge their XYLD bet with SVOL but many people don't feel comfortable with so much exposure to derivates. You should check your comfort level before deciding whether to invest in SVOL and how much to invest based on your risk tolerance. While SVOL will make money while volatility is dropping, it can lose money while volatility is rising. Hopefully your XYLD premiums will rise to make up the difference in that case though.

Should investors be worried about this reduction in XYLD's dividend payout? They shouldn't necessarily be worried but they should be prepared. They should realize that they won't always get a 12% yield from this fund that's actually the maximum amount. They should prepare themselves for this fund's yields to range from 6% to 12% depending on VIX and set their expectations accordingly. I would say that the same is also true with other covered call funds too (for example JEPI). Keep in mind that Nasdaq's volatility is different from VIX so funds that focus on Nasdaq (such as QYLD and JEPQ) will usually have different yields. VIX is specific to S&P 500 index but typically correlates with volatility in other indices but the correlation is never perfect.

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