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Go with the (cash) flow

Income investing today's buzz strategy, but it's not without risk

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GLOBAL equities, emerging markets, precious metals — they’re all flavours of the day that have taken on a sour note in the last few years.

Many investors also may be sensing a bitter taste for balanced strategies.

QUICK FACTS

Covered call? What kind of financialese are you speaking?

A covered call involves selling a call option on a stock that you own.

Sure, but what’s an option?

An option is type derivative — just not the over-the-counter kind that have caused all the trouble over the last decade. Unlike muchmaligned credit default swaps and collateralized debt obligations, options are traded on an exchange so their price is always public knowledge. Investors often use them to reduce risk on their investments — though they can be used to make risky bets.

So why would you use a covered call?

A covered-call strategy is designed to both reduce risk and create cash flow. The seller collects a premium on the sale of a call option to a buyer. In most cases, the premium payment is similar to a dividend payment. By purchasing the call option, the buyer now has the right to buy the stock from the option seller at a set price over a period of time.

It’s a covered call because the seller of the option owns the stock. The call option has what’s called a ‘strike price,’ which means when the stock rises above the price, the option buyer can elect to purchase the stock at the agreed strike price. After buying the stock at the strike price, the buyer can turn around and sell that stock in the market at a higher price for a profit. In most cases, the call option never reaches the strike price and expires with the option seller holding onto the underlying stock. The seller has earned income from the premium and keeps the stock. This strategy only works if the call-option seller has already made a capital gain on the underlying stock. Otherwise, if the call option is exercised, the seller must sell the underlying stock at a loss — which would likely outweigh the premium earned from selling the call option in the first place.

Still doesn’t make sense? Here’s an example that might help: Jim owns Ajax Toilet Paper shares he bought for $3 two years ago. They’re now worth $6. He doesn’t see much upside for Ajax in the near future, and he’d like to generate a little revenue by selling call options on the stock. Jim has 1,000 shares and sells call options on those shares, priced at five cents an option to a buyer for the right to purchase the shares at $7.50 over the next two months. Jim earns $50 in premiums.

Afterward, two basic scenarios might unfold: Ajax never exceeds $7.50 a share over the next two months and the option expires. Jim keeps his shares, earning $50 in premiums. Or, Ajax TP’s stock price exceeds $7.50. The price hits $10, for example, and the buyer exercises the option, buys the shares for $7.50 and then sells them on the market for $10. He profits $2.45 a share. Jim loses out on additional profits, but he is still ahead because he sold his shares at a $4.55 capital gain per share ($4.50 on the stock price gain and 5 cents on the option).

What about preferred shares and convertible debentures: Preferred shares are like common stock that issue dividends, but they have fixed dividend payment and generally don’t increase much in price. They are ‘preferred’ because dividends are paid before common shareholders are paid.

Convertible debentures or bonds are a bit like normal bonds, but pay less in exchange for the option to convert to shares.

— Investopedia

Investors may find no refuge from the storm of market volatility in GICs and bonds either, given the historically low interest rates.

These days, however, a new strategy has been getting a lot of hype as the solution to market uncertainty: income investing.

It might sound a lot like a bond or a dividend strategy and, in many ways, income investing straddles both.

But bonds and dividend stocks are just two of several means to earn income.

Income strategies can involve buying, holding and selling a number of different types of investments. Yet all income strategies share one thing in common, according to David Derwin and Joseph Alkana, two Winnipeg-based investment advisers with Union Securities.

"The name of the game is generating cash flow," Alkana says.

A decade ago, retirees — who often need income the most — could rely on GICs for a five per cent per year return with little risk.

But lately, investors are lucky to find a GIC paying a little more than two per cent per year.

And among most investment experts, GICS are viewed with disdain.

Derwin and Alkana, for instance, recently discussed the downside of GICs in their Market Watch weekly webcast to clients. Entitled Friends Don’t Let Friends: Invest in GICs they pointed out GICs pay so little, investors are actually losing money after taxes and inflation.

Investors have better ways to get paid to wait, Derwin and Alkana say. What they need is a multi-pronged approach to generate consistent returns, a strategy that includes dividend-yielding stocks, preferred shares, convertible debentures or bonds (can be converted to shares), options and corporate bonds.

While no one type of investment is a panacea by itself, when they’re all used together in a comprehensive portfolio, investors increase their chances of earning a return, even in choppy market waters.

And, indeed, the forecast calls for some stomach-churning waves ahead.

"We’re looking at the stock market in a sideways range for another five years," Derwin says.

"That means the market may be up 20 and down 20 per cent during that time."

Among the tools to generate income in a bearish market is a covered call strategy, he says.

Investors are paid a premium in exchange for selling a call option on stocks they own. The callcontract buyer receives the option to purchase the stock over an agreed period at a set price.

In most cases, the option to purchase the stock is never exercised, and the strategy is repeated again and again with the premiums generating income for the stock owner.

Covered calls, however, are not for the uninitiated and often require guidance from an adviser licensed to trade options.

Dividend stock investing is less complicated than options trading and has been a tried-andtrue strategy for many investors for a long time.

The upside of most dividend stocks is investors get paid a yield higher than GICs and they can eventually sell their shares for a capital gain.

The problem with dividend stocks is they’re prone to stock market risk.

Solid companies usually keep paying their dividend amidst uncertainty, but their share price can plummet, which can rattle the nerves of investors seeking security.

Even more troubling, many investors are now chasing companies with dividend yields of five per cent or more, which involves a lot more risk than they may realize, says Uri Kraut, senior wealth consultant with Assiniboine Financial Group.

"They have economic sensitivity because they’re paying out the vast majority of profits, so the second the profitability declines, they have to cut their dividend — and people don’t sell dividend cutters; they run from them, so you can see stocks prices crater."

Bonds offer more security than dividend stocks and are the traditional ‘go-to’ investment for income.

But investors need to buy corporate bonds, not government, to earn higher returns than GICs.

"Over the last 10 years, they’ve been one of the best riskadjusted investments we could find," Derwin says. But that’s the past. Today, the highestquality corporate bonds yield about three per cent or even less for a five-year term to maturity. To earn more yield, investors need to uncover fixed-income opportunities that fly below the radar, Derwin says. This means they need to do their homework, sifting through a company’s financial statements for clues of profitability.

Furthermore, buying individual bonds — and stocks too — pose another problem for many investors. Most people don’t have the money to buy enough different securities to be properly diversified.

The minimum requirement is about $250,000, Derwin says.

Even then, most Winnipeggers with that dough are going to be more interested in preserving it rather than increasing its value, Kraut says.

"The average human being with that kind of money actually needs some of it to be safe," he says. "It can’t all be rock and roll in the stock market."

In reality, most people have much less money, so they rely largely on mutual funds for diversification.

Investors do have plenty of choice for income funds. Some even offer four to six per cent annual distributions.

Still, investors need to be cautious about chasing yield, says Stuart Graham, head of PIMCO Canada, which specializes in fixed-income investing.

While a fund strategy may promise a four, five or six per cent distribution per year, the fine print may come as a shock to the uninformed.

A promised five per cent annual distribution may be made up of a combination of a return on investment and a return of capital.

"Even though a fund states a five per cent distribution, all that’s happening in this situation is you may be getting your money back," Graham says.

"You’re basically paying a management fee for them to distribute your capital back into your bank account."

Kraut says most investors shouldn’t be using these funds to produce income they need for dayto- day use in the first place. He prefers creating a portfolio of bond funds, equity funds and, yes, even GICs for short-term income needs.

"Let’s say you’re going to buy a car in two years for $25,000 and use GICs to purchase it," he says. "In that case, a negative return of 0.5 per cent two years in a row is financially inconsequential."

Sure, an all-GIC portfolio won’t get most investors to their long-term goals. An income-oriented strategy designed to produce a return year in and year out above inflation is certainly a better alternative.

But investors don’t want to stretch for too much yield above the risk-free rate of a GIC if they’re concerned about protecting their money from losses, because the days of big, easy returns are likely over.

"One of the things that Bill Gross, the chief investment officer with PIMCO, is famous for saying is people have to realign their expectations of what is normal now for earnings," Graham says.

"People got accustomed to very high single-digit returns for much of the last 20 years, and it was really an anomaly and likely not coming back anything soon."

giganticsmile@gmail.com

Republished from the Winnipeg Free Press print edition September 1, 2012 B9

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