Covered Call Funds To Add Volatility?

Steve Laipply from iShares was on ETFIQ on Bloomberg Monday talking primarily about fixed income ETFs. Included in iShares fixed income lineup are three bond ETF buywrite funds. So the iShares 20+ Year Treasury Bond Buywrite ETF (TLTW) essentially owns TLT, a long duration bond fund, and sells covered calls against the shares of TLT. iShares also has Investment Grade Corporate Bond Buywrite ETF (LQDW) which corresponds to LQD and there is also the iShares High Yield Bond Buywrite ETF (HYGW) which corresponds to HYG.

The yields on these are sky high. If you look at Yahoo finance you'll see high teens looking back, Laipply said they've come down some to the low to mid teens which is still very high of course. Something to keep in mind as we go through this is we are currently in a 5% world. If you can find 6% or 7% somewhere then you are taking a little more risk but a 15% yield in a 5% world takes on a lot of risk. That's a point that cannot be minimized. Here are charts comparing the original to the buywrite versions YTD.

 

 

The funds started in mid-2022 but giving the benefit of the doubt, I will assume that last year was an anomaly in terms of magnitude of decline.

 

I'll just throw in one since inception chart for context but all three look similarly bad in the same time frame.

The LQDW/LQD chart shows what can go wrong. They went down in lockstep which is ok. Then LQD started to rally and it looks like LQDW stopped at the strike price of an option sold (pegged was the jargon 25 years ago) and missed a huge bounce from November into December. From there, the charts look similar. Sticking with LQDW/LQD, Yahoo Finance says LQDW is up 5.13% YTD on a total return basis versus 2.01% for the underlying LQD. TLTW total return this year is 3.94% and TLT is -3.17%. HYGW total return this year is 6.82% while HYG is 5.41%.

These can work but one problem is they may not be able to bounce back after a crash. There are probably other problems that could arise as well, remember these pay 15% (very rounded) in a 5% world.

With the bond buywrite ETFs, the prices of the funds are not keeping up with the ex-dividend reductions which puts the possibility of depletion on the table.

Single stock, covered call ETFs is another new type of product add to this conversation. Let's look at a couple of those. You can go to the YieldMax site to look at more of them. I chose Apple (AAPL/APLY) and Nvidia (NVDA/NVDY) because they're part of the first batch so we have a longer track record to look at. To be clear, these have not been around very long. 

 

 

Portfoliovisualizer is showing total return, not just price performance. In terms of just price performance the numbers are quite different. With Apple, the covered call ETF lags the common almost 13% and with NVDA, the covered call ETF lags the common by 45%. The YieldMax website says the distribution (annual) yields for the NVDA and AAPL products are 49% and 14% respectively. I don't really understand why it is ok to project a yield based on the vagaries of the options market but apparently they can. The stocks that have been packaged into the YieldMax products are a mix of hot potatoes like NVDA and TSLA where the "yield" is in the forties and more mature tech names with yields in the mid teens. 

It's a 5% world so there's plenty of risk with a 15% yielder, all the more so with a 40% yielder. 

Between starting this post on Monday night and finishing on Tuesday, I stumbled into the Kraneshares China Internet and Covered Call Strategy ETF (KLIP) which is the Kraneshares China Internet ETF (KWEB) with a covered call overlay. KLIP started in January, is a monthly pay and so far has paid out about $8 against it's current price just under $18.00. The fund came out at $25 so it is down $7 and has paid out $8.

Note that Portfoliovisualizer doesn't pick up January but if I grabbed the chart from Yahoo, it wouldn't pick up the dividends. The idea of eight steps forward and seven steps back seems like a tough way to make a living but it's worth studying.

Covered call strategies are often packaged as a way to reduce volatility. The funds we've looked at in this post might technically do that, not certain, but either way they are not themselves low vol products. These are proliferating. As I looked for information to write this, I got served ads on Google for all sorts of covered call funds I've never heard of before. 

If you're going dabble in any of these, dabble is probably a good way to size these if at all, make sure you understand what you're getting. TLTW in its short life has had a higher standard deviation than the S&P 500 with just a fraction of the return. These funds can play a role in a diversified portfolio. There are probably multiple ways to slot in a small exposure including barbelling yield. I don't mean building a fixed income barbell, I mean barbelling volatility/yield such where a small allocation to a couple of these hot potatoes provides a disproportionately high percentage of a portfolio's income. 10% split between one of the bond ETF buywrite funds and single stock covered call ETF with the other 90% in a 5% T-bill doesn't seem like an unreasonable concept to consider while these things give a better sense of what they will actually do. 

I have always been intrigued by covered calls and funds that use the strategy. For all of my interest here, I still have only dabbled in these which is worth pointing out. 

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