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Feb. 22, 2021, 7:55 a.m. EST

These ETFs can give you high dividend yields with relatively low risk

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By Philip van Doorn

How high is high, when it comes to dividend yields?

For investors who need income, standards have changed. Long gone are the days when you could enjoy a 5% yield on a tax-exempt bond with a high credit rating.

All is not lost. Investors holding stocks can make use of covered-call strategies to provide additional income as well as downside protection. That strategy is described below, along with examples of two ETFs that can make it much easier to to use the strategy with a diversified portfolio.

Looking beyond Treasurys

Mark Grant, B. Riley Financial chief global investment strategist for fixed income, summed up the unfavorable environment for bond investors in his “Out of the Box” email Feb. 16: “The year-over-year CPI Inflation rate is currently 1.4%. The Bloomberg U.S. Treasury Index, with a duration of seven years, currently yields 0.718%, which shows an actual loss of 68 basis points to Inflation.”

Some investors look for income from preferred stocks, but most of those are trading at tremendous premiums to their par values, which means when they are redeemed by the issuers, investors who have paid those premiums will take significant losses.

Grant suggests using “carefully selected closed-end funds, and some exchange traded funds.”

In the following discussion about fund dividend payments, the word “distribution” is used, because the income investors draw from the investments isn’t only dividends. For the ETFs described below, the monthly distributions include premiums from the sale of call options.

You or your investment adviser need to be careful with closed-end funds to understand how high they may be trading when compared to their net asset values and also because many will return your own capital to you as part of the distribution. That may not be a bad thing, as it can keep a closed-end fund manager from cutting the distribution temporarily, or there may be tax advantages to the capital return. But the return of capital comes out of the NAV, which means over time, a continual return of capital will cause the share price to decline. All of this may still work out to a good total return, but it may be difficult to remain comfortable while watching your share price fall.

How covered-call options work

An investor who purchases a call option can buy shares of a stock or ETF for a specific price until the option expires. A covered-call option is one that you sell when you already own the shares.

Let’s say you buy shares of a $100 stock that has an attractive dividend yield and you are confident the company will be able to maintain or raise the dividend. Let’s also assume that although you like the company, you would be willing to let the stock go for $110 a share. You can sell an option to another investor allowing them to purchase your shares for $110 (the strike price) by a certain date. You receive a premium for selling the option. If the stock never rises sufficiently above $110 for the option buyer to exercise it before the option expires, you keep the premium and your shares, the dividends continue to flow and you are free to sell another option.

If the price rises high enough for the option buyer to exercise it, you keep the premium for selling the option, plus your profit on the sale of the shares, plus the dividends you earned in the meantime.

Ken Roberts, a registered investment adviser based in Truckee, Calif., provided an example of a covered-call option during an interview Feb. 16.

Shares of Intel Corp. /zigman2/quotes/203649727/composite INTC -0.51% closed at $62.47 on Feb. 16, and with annual dividends of $1.39 a share, the dividend yield was 2.25%. If you held Intel at that time, you could have sold an April 16 $67.50 covered-call option, with a bid of $1.64.

That means if the share price were to rise above $67.50 by April 16, you would be forced to sell your Intel shares. But you would have gained 8% from Feb. 16. If the share price were not to rise above $67.50, you would still own your Intel shares and would keep the $1.64 per share you earned when selling the call option, which would be “good for a two-month investment,” Roberts said.

That’s a tidy sum to earn in 59 days — more than your entire annual dividend.

If you kept the Intel shares, you would be free to keep writing covered-call options until someone exercised them. You would effectively increase your yield on the shares until selling them at what you considered to be an attractive price.

You can also consider the covered calls to be downside protection, because you have repeat income from selling new options as the old ones expire.

/zigman2/quotes/203649727/composite
US : U.S.: Nasdaq
$ 49.25
-0.25 -0.51%
Volume: 32.22M
Dec. 3, 2021 4:00p
P/E Ratio
9.56
Dividend Yield
2.82%
Market Cap
$200.30 billion
Rev. per Employee
$704,042
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