The Downside Of Derivative Income Funds

One of the reasons I have been negative on bonds with duration is that they take on equity beta and the correlation to equities is no longer reliable in my opinion making for less effective protection against equity volatility. Of course in the last few days, bonds with duration have rocketed higher....which I would cite as an example of equity volatility. 

We've looked a couple of times at derivative income (covered call) bond ETFs including the iShares 20+ Year Treasury Bond BuyWrite ETF (TLTW) which tracks TLT with a covered call overlay. TLTW shows a yield of 16% on Yahoo Finance versus 3.86% for plain vanilla TLT. 

TLTW has been around for two years and is down 39% on a price basis since then. On a total return basis, it is down 8.9%. In the same period, plain vanilla TLT is down 16% on a price basis and down 9% on a total return basis. Note that TLTW started trading after the worst of the 2022 bear market.

You can see in the chart that TLTW is now flattening out while TLT is going up at an increasing slope. To the left of the chart, it shows the price of TLT at $95.31. Looking at the TLTW website, it is short calls struck at $96 that expire this month. It doesn't say what day this month they expire, they are flex options not regular options that you or I could access in a brokerage account. 

If TLT keeps going up, TLTW won't participate. When the August options expire and they sell the next month's option, if the price of TLT keeps going up, it will get left further behind. 

Mark Yusko says risk happens fast and this is an example of upside risk happening fast. Parking heavy into a derivative income fund is not a great idea as I've said many times. I think there are a couple of equity funds in the space that don't completely kneecap the upside that I've mentioned in other posts so if there are a couple that I know about there are probably some others too but most of them have almost no upside but expose holders to most of the downside. 

We looked at one example where 90% into the plain vanilla and 10% into some derivative income version could make sense. An example of what I mean is if you have $10,000 for a broad based equity index fund, maybe $9000 goes into the plain vanilla version with 10% going into a derivative income version. It would obviously increase the yield and the growth from the 90% would more than make up for the erosion of the 10%. 

Where I have no interest in owning something like TLT, I haven't given any thought to using TLTW in the manner I just described. 

The information, analysis and opinions expressed herein reflect our judgment and opinions as of the date of writing and are subject to change at any time without notice. They are not intended to constitute legal, tax, securities or investment advice or a recommended course of action in any given situation.