2023-05-17 10:50:15 ET
Summary
- Covered call funds are becoming very popular for income-seeking investors.
- These funds are not limited to stocks.
- HYGW sells covered calls on corporate bonds and offers a yield of almost 16%.
Lately covered calls have been very popular and well-received by market participants who are looking for higher income yields for (slightly) less risk. Funds like JEPI, QYLD, JEPQ and XYLD are on the news every day and if this trend continues we will see more products that generate income from options. One less known such fund is iShares High Yield Corporate Bond BuyWrite Strategy ( HYGW ).
This fund basically writes covered calls on a basket of high yield corporate bonds for a dividend yield of 15%. Roughly 5-6% of the dividend yield comes from bond yields while the remaining 9% or so comes from covered call premiums.
For its main vehicle, the fund uses High Yield Corporate Bond ETF ( HYG ) which is also issued under the same brand name (iShares). This fund has been around since 2007 and survived the Great Financial Crisis of 2008 just fine. It holds a basket of more than 1200 funds from a variety of companies from more than 10 different sectors. In public high yield corporate bonds are also known as "junk bonds" but this doesn't mean they are worthless. This means they have a higher probability of defaulting compared to A-rated bonds but when you have a basket of 1200 bonds, even if some of them default the fund itself is diversified enough to be fine.
HYGW has been around for less than a year but when we look at the total return chart we see that it never dipped that much since its inception even though Fed has been hiking rates for a year straight. Since its inception the fund's total return has been flat because its price drop has been offset by its dividend payments so far. Keep in mind that historically last year was one of the worst years for bonds in modern history regardless of their credit rating. Moving forward, once bond yields stabilize, this fund should result in higher total returns.
One thing that caused bond yields to jump and bond prices to crash in the last year was persistently high inflation. While headline inflation numbers have been declining sharply, we are still seeing high and stable core inflation numbers in both core-CPI and core-PCE. This part of the inflation can prove to be highly sticky in the near term and even medium term if Fed pivots anytime soon. While this will not necessarily crash bonds, it could keep them from rallying in the short term. Since HYGW sells covered calls against its bond positions, the fund doesn't really have much incentive for bond prices to rise anyways.
When investors think of "junk bonds" they might immediately think about companies that report losses year after year with no hope of ever reaching profitability but most companies whose bonds are considered "junk" are actually profitable. Below are some examples of companies that are represented in this junk bond fund:
- Ford ( F ): Ford's credit company's bonds are rated in junk territory because of the troubles the company had many years ago but Ford is highly profitable right now with very little risk of missing any payments in my view. In the last 12 months, the company posted nearly $7 billion in operating profits and $3 billion in net profits. HYGW holds a variety of Ford bonds and these bonds have a combined weight of 2.5% in the fund.
- Tenet Healthcare ( THC ): This is another company that's highly profitable and should have no trouble making its debt payments even though it has a junk rating and it is one of the biggest holdings in HYGW. In the last 12 months the company posted $2.8 billion in operating profits while its debt interest payments totaled $884 million which the company had no trouble covering.
- Occidental Petroleum ( OXY ): One might be surprised to see this company's name under HYGW because it's highly profitable, enjoys a strong balance sheet and appears to be one of Buffett's favorite stocks. In the last 12 months the company generated $12 billion in operating profits and its debt payments only totaled a fraction of this ($715 million). It's clear that OXY has very little risk of defaulting anytime soon.
Of the total debt this fund holds, 22% comes from the consumer cyclical sector, 17% comes from the communications sector, 13% comes from the consumer non-cyclical sector, 11% comes from energy and 10% comes from capital goods. Only 7% of the debt comes from technology and only 3% comes from financial industries, so only a fraction of the total debt held by this fund comes from those sectors where people expect to see a lot of defaults when easy funding dries up.
50% of the debt held by HYGW is rated BB and another 37% is rated B by rating agencies. While these ratings are still considered "junk grade" they are actually at the higher end of junk rating. Many of these bonds are one or two upgrades away from becoming investment grade. Only about 10% of the bonds in this fund (by total weight) are rated CCC or below which are considered the riskiest. Considering that most bonds held by the fund (64%) are expected to mature in 3-7 years, I believe most of these bonds will be fine.
Sometimes a company's debt will receive one or more upgrades and it will not be considered in junk territory anymore. When that happens, the bond gets sold from this HYG because HYG only invests in companies with lower ratings. Luckily iShares also has an investment grade version of this fund called LQD ( LQD ) and it also happens to have a covered call counterpart ( LQDW ). This fund also has a high yield of 14.5% and investors who want to feel safer can put their money in this fund. As a matter of fact, iShares also has a US government bond version of the same fund ( TLTW ) which writes calls on government bonds. I actually recommend buying all three in small amounts for the sake of diversifying.
In the future I expect to see more types of funds like this since these funds proved to be highly popular with investors, especially those seeking income. There are some covered call funds that sell covered calls on specific assets and commodities such as oil ( USOI ) and gold ( GLDI ) but these typically have poor track records of performance so I don't feel very comfortable with holding them. Bond funds are more preferable for investors looking for high yields than commodity funds because bonds have their own yields in addition to the yield you get from covered calls which almost doubles the total yield.
Last year was a terrible year for bonds overall as Fed hiked rates from almost 0% to 5% (one of the fastest rate hike campaigns in history) but some bond funds still held up pretty good overall. I was actually expecting corporate bond yields to go much higher than they are today but they didn't. When Fed's funds rate was near 0%, many corporate bonds yielded 3-4% and now with Fed funds rate at 5%, they yield about 4-6%. Maybe this is because most corporate bond investors don't expect inflation to last long or they expect the Fed to start cutting rates soon. In either case, I don't think corporate bond prices will drop much lower from here and it might be a good time to load up on these.
Of course I must mention the risk of a recession. If we end up getting a severe recession (also known as "the hard landing"), many junk bonds might drop significantly while investors flee to safety of government bonds and A-rated corporate bonds. This is why it's important not to put all your eggs in HYGW and diversify your money between HYGW, TLTW and LQDW for the added benefit of safety while maintaining the high yield.
For further details see:
HYGW: High Yield Bonds Meet Covered Calls For A 15% Yield