Finding Double Digit Yields In Today's Market

Amy Calistri's picture

Monday, October 12, 2009 - 9:55am

by Amy Calistri

Looking at the yields on junk bonds today, I'm reminded of a Joanie Mitchell lyric many years ago: "Don't it always seem to go that you don't know what you've got till its gone."

In October 2008, the dividend yields for speculative-grade (junk) bonds were averaging 2,182 basis points above Treasury yields. Sure, the economy looked scary back then. But for a 21.8% yield, many income investors thought it was worth it. The junk bond default rate, although clearly on the rise, was only 3.2%.

This week, the credit-rating agency Moody's announced the junk bond default rate was up to 12.9% for the third quarter. And investors looking at the junk bond market today for those delicious 20%-plus yields will be sorely disappointed. The yield premium for junk bonds has dropped to roughly 750 basis points.

In March 2009, real estate investment trusts (REITs) were trading at a -45.3% discount to the value of their real estate holdings -- the cheapest they had traded for more than 15 years. The average REIT yield was just above 10%.

Today, the risk vs. return scenario isn't as sweet for REITs. According to the research firm Green Street advisors, REITs are currently trading at a +24% premium to their net asset values. And the yields? Not as good as they once were, falling to an average of about 7.5%.

So now that risk doesn't pay, where should investors look for income?

Clearly the S&P 500 is out; the average dividend yield for the index is just 2.3%

The 3.4% yield on the 10-year Treasury isn't much better.

One alternative is a closed-end fund that employs a covered call strategy. Generally, theses funds own solid dividend paying equities. To get generate additional income, the fund will also write (sell) covered calls on a percentage of the portfolio's holdings.

These call option contracts are typically written out of the money (with strike prices above current market prices), which allows for a fair amount of upside participation before they are exercised.

In a flat or declining market where those strike prices aren't reached before expiration, the fund can write multiple contracts against the same holdings and pocket millions in upfront premium income. Should the market rise substantially, any gains beyond a certain point will be forfeited. But most funds only write them against a percentage of the fund's assets -- the rest are unencumbered and free to fully participate in any rally.

One example is the Eaton Vance Risk-Managed Diversified Equity Income Fund (NYSE: ETJ), which holds stable equities like Exxon Mobil (NYSE: XOM), International Business Machines (NYSE: IBM), and Wal-Mart (NYSE: WMT). The fund also writes covered calls on approximately two-thirds of its holdings, enabling it make distributions with a current 10.5% yield.

More aggressive income investors may like the S&P 500 Covered Call Fund (NYSE: BEP). It invests in every stock on the S&P 500 index and then writes calls on the S&P 500 Index. Right now it is trading at an +8.5% premium to its net asset value (NAV), which is slightly above its three-year average premium of +3.26 (3.3%). But the fund is also paying out a 17.8% yield -- and that may be a risk vs. return equation worth considering.

Amy Calistri does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.