Covered calls: a strategy for the spotlight

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It is a paradox that income has returned to the centre stage of investment just when reliable sources of it are so scarce.

Interest rates on cash are at rock bottom. The yield on a 10-year UK or US government bond is just more than 2 per cent. Once you have allowed for inflation, holding these assets is a recipe for loss. And that is not allowing for the potential for capital loss by holding government debt at this stage in the economic cycle. Investors will have to look beyond traditional options for income.

Step forward equities: the yield on the FTSE 100 index of large UK stocks exceeded that of 10-year UK government bonds early last year. This premium does not look like reversing any time soon.

Fixed interest has long been investors’ favoured source of income. However, one lesson from the financial crisis of 2007-09, when credit markets froze, was that liquidity can be a problem for bonds in extreme conditions. Stockmarkets, however, remained liquid.

The outlook is a positive one for income from dividends. Companies are, in general, well capitalised. They have a number of choices available to them with regard to the piles of cash they are sitting on. They can invest it in growing organically, heading down the mergers and acquisitions trail or returning it to their investors by paying them dividends or buying back shares. For now, the most likely route is the latter. But investors have become uneasy about equity exposure since the financial crisis.

Demand for lowering the risk of equities and enhancing their yield has been a long term trend. It ties in neatly with the recently coined phrase, “demographic disdain for equity risk”.There are three elements to this:

• “Safe yield” is in demand, as investors shun “average” expected returns from equity markets while risk is still perceived to be heightened

• Demographics continue to support bonds over equities. This is because developed markets have age profiles increasingly skewed upwards, implying an ingrained preference for ‘safe’ assets

• Emerging market savers aren’t helping either, being discouraged from equity investments due, among other reasons, to less regulated companies and markets

The areas of the equity market with the high quality companies, strong balance sheets and high dividends are in demand, with much of the rest failing to fit investors’ requirements for safety and yield. In short, investors increasingly want a reliable source of income from equities, without the rollercoaster volatility.