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Published: October 12, 2009
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
Editor
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