(By Carla Pasternak) This is not your grandmother's market
You can't invest in blue chips like Procter and Gamble (NYSE: PG) or Johnson & Johnson (NYSE: JNJ) and expect to receive the same dividend yields of 5% or 6% that you could 30 years ago.
In 1981, S&P 500 stocks threw off an average yield of nearly 6%. Today, these stocks give you around 2%.
But there are funds that invest in America's blue chips and carry yields north of 10% in the process.
I'm talking about closed-end covered call funds.
These funds generally own a portfolio of solid dividend paying stocks and generate additional income by selling call options on a portion of their portfolio holdings.
The additional income, or premiums, they get from selling options allows them to pay higher dividends than their underlying holdings would provide.
For example, BlackRock Enhanced Capital & Income (NYSE: CII) owns 54 blue chip names such as Bristol-Myers (NYSE: BMY), Kraft (NYSE: KFT), and Pfizer (NYSE: PFE) with average yields of 4% to 5%. But the fund pays out an 11% yield by selling call options on about half of the portfolio stocks and collecting the premiums.
If the strike price (stock price at which the option can be exercised) isn't reached because the price declines, the option expires worthless, and the fund can pocket millions of dollars in premiums by writing options on the same stocks.
These premiums help offset the decline in the fund's underlying portfolio, allowing the fund to outperform its equity indexbenchmark in weak markets.
In May, the S&P 500 lost nearly 7% and volatility, as represented by the CBOE Volatility Index, popped 41% over the previous month. That's the kind of environment covered call funds can thrive in. And many did, with 22 of some 31 covered call funds outperforming the benchmark S&P 500.
In strong markets, the covered call strategy takes some finessing. A covered call fund runs the risk of getting the stocks called away and needing to buy them back at a premium or else buy back the option at a generally higher price before it's exercised.
As a result, funds that write options against only a portion of the assets, leaving the other portfolio stocks free to appreciate, are more likely to outperform in rising markets.
Funds also preserve the upside potential of their holdings by selling index options instead of individual stock options.
Unlike stock options, which require delivery of the underlying security, index options are usually settled with cash. That way, the portfolio holdings can be left to appreciate even if the option is exercised.
Funds can further protect upside by writing out-of-the-money call options. The difference between the strike price and the current market price is greater on these options than on in-the-money (priced below market) or at-the-money (priced equal to market) options, which can be exercised immediately.
As a result, out-of-the-money options don't command as much of a premium but allow the underlying stock or index to appreciate typically around 1% to 3% before being exercised.
With these pointers in mind, I screened for covered call funds with strategies that position them to generate positive returns in good times and bad.
I focused on funds that:
1. Write options on 60% or less of portfolio holdings, leaving the rest free to appreciate in an up market.
2. Write index options, leaving the portfolio stocks free to appreciate.
3. Write mostly out-of-the-money options, allowing some appreciation before the option is exercised.
Here's what I found...
The top performer, Cohens & Steers Global Income Builder (NYSE: INB) bears watching. INB invests in a portfolio of global large-cap companies with relative stability. It's also the only one on my list that uses leverage to enhance returns.
As a result, INB has performed best in rising markets when the fund's leverage helps boost returns. In 2009, the fund delivered total returns of 67%, more than twice the S&P 500's 27%. If history is any gauge, a market recovery this year or next could see the fund strongly outperform once again.
Risks to Consider: As with all investments, these funds aren't without risk. Covered call fund distributions generally contain large doses of return of capital. Therefore, it's important to check the fund's balance sheet to see if the return of capital is reducing its asset base.
Action to Take --> If you're looking for a creative way to invest in America's largest companies, and boost your yields in the process... a covered call fund could be a suitable investment idea for you.
-- Carla Pasternak
Carla Pasternak does not personally hold positions in any securities mentioned in this article. StreetAuthority LLC owns shares of PG, JNJ in one or more if its "real money" portfolios.
This article originally appeared on StreetAuthority
Author: Carla Pasternak