Income Investors Could Almost Double Their Yield With This Trade

Retirement planners usually advise investors to hold a combination of stock market and fixed income investments in their portfolio. Investments could include mutual funds, ETFs, or individual securities. Ten-year Treasury notes offer a yield of 1.85%, which means an investor using traditional planning tools would earn about $185 on a $10,000 note.

Because interest rates have fallen so low, many investors are taking on more risk in pursuit of more income. This decision could lead to devastating losses if market conditions change suddenly, like they did in 2008. Rather than shifting assets to excessively risky investments, income investors should consider a different way to use traditional investments.

 

Fixed income investors can diversify with real estate, which is also an income producing investment. Investors can participate in that sector by buying real estate investment trusts (REITs), but picking the right REIT can be a challenge.

Under IRS rules, REITs are required to pay out a high percentage of earnings as dividends. Since the earnings can be increased by depreciation and other accounting charges, the dividends can consume a large amount of the cash flow, which puts the REIT at risk of being unable to fund its operations. Rather than trying to find the best REIT, we can use the Vanguard REIT Index ETF (NYSE: VNQ) to track a REIT index that invests in companies owning office buildings, hotels and other real property.

VNQ reports a dividend yield of about 3.6% based on the payments from the past 12 months and generally pays a dividend quarterly. The specific payment amount varies and tends to increase in the fourth quarter. In the first three quarters last year, the dividend averaged 51.5 cents. Assuming a similar payout over the next 12 months, we can conservatively estimate that the income from VNQ will be about $2, or about 3%.

While 3% is a low yield, it is significantly higher than the yield of long-term Treasuries. In addition to higher income, VNQ also offers potential capital appreciation. Realistically, there is very little potential upside in bond prices after a 30-year bull market.

With covered call option writing, we could increase the income from VNQ. This strategy is not really any riskier than owning VNQ outright. If VNQ falls, the covered call writer and the stock owner who doesn't use covered calls will experience a loss. But the covered call writer's loss will be smaller. If VNQ goes up, both investors will gain, although those gains are capped with a covered call. The biggest difference is that covered calls could almost double the annual income from 3% to 5.4%.

Rather than describe this idea in theoretical terms, let's dive in and use real numbers. At the time of this writing, VNQ was trading at $68.09 a share. You could buy 100 shares of VNQ and sell a call that expires in March with a strike price of $70 for 28 cents. Each options contract is for 100 shares of stock -- selling this call generates $28 in income immediately. Over the next two months, if VNQ announces a dividend, and they have paid a dividend in March in the past, you'll receive the dividends just like you would if you hadn't written a covered call.

When the option expires, if VNQ is trading above $70 you will have to sell the shares at $70. Assuming you sell the shares, the total return would be about 3.2%, or 1.6% a month. This profit comes from the $28 options premium and the profit on the shares. If there is a dividend payment of 51.5 cents, that return could rise to 4%.

If VNQ is below $70 at options expiration, we see a return of about 1.2% from the dividend and options premium and will be able to sell more calls. Repeating this strategy throughout the year could increase your annual income from VNQ to 5.4%, assuming we find similar trades five more times a year ($0.28 x 6 = $1.68 + $2 dividend yield = $3.68/$68.09 x100 = 5.4%).

Markets are always changing and investors need to adapt. In a low interest rate world, writing covered calls is one way to adapt and profit.

> Buy VNQ at the market price and sell one VNQ March 70 Call at the market price for each 100 shares of VNQ purchased. Set stop-loss at $64 on VNQ but do not use a stop-loss with the call. If VNQ falls, the call will expire worthless and the income received will partly offset the loss in VNQ. If VNQ closes below $70 when the options expire, the income from the options premium and dividend would be 1.2% in two months. If VNQ closes above $70, the stock will be called away and your profit will be 4% in two months, including dividends.