treasury rates 3, Double Treasury Rates

Just when you thought treasury interest rates wouldn't go lower, they do. For a fixed income investor today's treasury rates are painfully low. Even if you have a $1 million retirement portfolio you can only generate $26,400 in interest per year for the next 10 years. Very difficult to live on these rates (August 3, 2011):

Duration Yield
1 year 0.16%
3 year 0.52%
5 year 1.25%
10 year 2.64%

Fortunately, there is an alternative that yields at least double current treasury rates. The strategy is to buy dividend champion stocks and write calls against them. Yes, there is some equity risk. But in exchange you remove a lot of inflation risk of treasuries (and other bonds).

Dividend Champions are those companies that have raised dividends for 25 or more years in a row. They are mature, large cap, typically well run companies that would bend over backwards before reducing their dividend payout and destroying their 25+ year history of dividend increases.

Download the dividend champion list in Excel.

Given their long track record, most investors consider the dividends of these companies to be relatively safe from the threat of dividend reduction. These companies are committed to their dividend policy and payouts. As examples, here are the top 6 dividend champions and their current dividend yields:

Dividend Champion Symbol Sector Div Yield
CenturyLink CTL Telecom 8.4%
Pitney Bowes PBI Business Equip 7.2%
Old Republic Intl ORI Insurance 6.9%
Cincinnati Financial CINF Insurance 5.9%
AT&T T Telecom 5.8%
Altria Group MO Tobacco 5.8%

Now, already you can see that these dividend yields are two to three times the 10-year treasury rates. But there is the risk the stocks will go down. Even though their high dividend yields act as a natural buffer to slow down any decline in stock price (i.e. if CTL drops 7% in stock price then the 8.4% dividend becomes a 9% dividend - very attractive to yield hungry investors), it would be nice to have some downside protection...

How to add protection? By writing in the money calls against your positions. The choice of how far in the money to write the calls depends on how much downside protection you'd like. And, of course, the more protection you choose the less call premium yield you will receive. Generally, for a typical 3-5% dividend yield large cap stock, you can get at least as much from the call premium as you earn from the dividend (effectively doubling the dividend).

For example, here are two chocies for CTL along with their respective downside protections provided by the call option, as well as the annualized call premium yields:

Symbol Price Call Option Downside Protection Annualized
Call Premium
CTL $29.50 Sep 27 9.0% 3.2%
Sep 28 6.1% 7.3%

That means that if you were to buy CTL today and write the Sep 27 call you could earn 3.2% per year in call premium plus receive the 8.4% dividend, for a total yield over 11% per year. As long as CTL stays above the strike price of 27 you are protected by the call option. If CTL drops below 27 then you would have a loss, although the annual dividend ($2.90) provides some additional protection.

If you wanted a little more call premium you could sell the 28 strike instead of the 27 strike, and get 7.3% annualized yield from the call premium, plus the 8.4% dividend for a total yield over 15%. But you have less downside protection in that case (i.e. more risk).

Of course, because you are writing in the money calls there is no upside potential for capital appreciation -- this is purely a yield play designed to do better than treasury rates for fixed income investors.

Writing in the money covered calls on large cap, high yield dividend paying blue chip stocks is a strategy that should out perform treasury rates, albeit with some equity risk. Stay diversified across industry sectors and use appropriate position sizing. If your dividend champion stock is called away from you then you can just buy it back the following Monday and start again. The combination of call premium plus dividend yield is one of the more popular investment strategies as an alternative to low-yielding treasury rates.

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