Media members observe the stock quotation board at the Tokyo Stock Exchange in Japan, Aug. 6.Willy Kurniawan/Reuters
Some Canadian exchange-traded fund providers have recently launched products that seek to take advantage of the increase in bond price volatility using a strategy called covered call writing.
Simply put, covered call writing reduces volatility in bonds, which especially flared up after the multidecade bull market in fixed income ended in 2021. The strategy can enhance income, too.
But investors should know what they’re getting themselves into when it comes to covered-call ETFs – and that’s especially true when it comes to fixed-income products such as bonds.
A strategy of using covered calls is mostly used in conjunction with stocks but has been adapted to be used with bonds and even Treasury bills. Simply put, the manager owns a security and “writes,” or sells, a call against their position. That call has an expiry date, and if the price of the security is above the predetermined strike price at the time of expiry, the holder of the call sells at the strike price, even if the price of the security is higher. If the bond is below the strike price on the option-expiry date, the option expires worthless, and the call seller pockets the premium.
Option analysis, behaviour and pricing are quite complex, but we will illustrate this strategy with a simple example.
Assume that we own a 30-year bond with a yield and coupon of four per cent, priced at $100. We write (sell) a call set to expire two months from today for $1 at a strike price of $102, or $2 over the current price. If the price rises above $102, the holder is compelled to sell his bond at $102. That means the call seller has earned about 3.67 per cent, in two months: They have accrued 0.67 per cent in interest (four per cent over two months), the 2 per cent difference between the initial price and strike price ($102 less $100), and the $1 premium on the call. If the price of the bond falls or is below the strike price at expiry, the investor pockets the $1. If the bond price falls to under $100, the call writer is still better off because they pocket the option revenue.
Covered call writing caps your upside and lessens losses, slightly. It works best in a sideways market when option premiums – the income received by the seller in an option contract – are high. On a risk/return basis, it is an effective strategy, but only if the underlying investment is volatile, options are relatively expensive, and costs can be minimized. In my view, the bid-ask spread alone (the difference between the price an option is sold or bought at) makes this strategy less desirable than one would think. The investor is also paying this spread a few times a year, owing to the fact they need to keep rewriting their call positions (Typically, an investor only sells at an expiry date a few weeks or months away, so they have to do a few writes per year).
Although writing covered calls on bonds seems like a new and innovative strategy, it has been around for a long time. In fact, I managed the covered call program in the 1980s for a trust company that was eventually absorbed by a major Canadian bank.
We wrote options on everything from government bonds to stocks to convertible bonds. The program was quite profitable so one might assume that I am a big proponent of writing calls on bonds now.
That assumption would be very wrong.
Markets change, and some very successful strategies have short shelf lives. Back in the early 1980s, yields on long-term treasuries were about 12 per cent – more than three times current levels – and volatility was extreme. Canada bonds yielded even more than their U.S. counterparts. Between 1974 and 1992, long-bond yields ranged from 7 per cent to over 15 per cent. Option premiums reflected this volatility. Yields and volatility are a fraction of what they once were, and returns are far lower. Combining this with the costs of the bid-ask spread and the management expense ratio of a fund of just below 0.5 per cent, the case for buying a bond-covered call ETF becomes weaker.
In my view, covered call writing strategies should be actively managed and not robotically follow a set of predetermined rules. Price outlooks change, and so do volatility levels. Writing calls makes sense when investors are paid for putting a cap on their upside. The strike price and expiry date are also crucial and must be understood. Manager expertise and ability are crucial. An excellent covered call manager requires a great deal of investment knowledge and mathematical ability. The buying “a good stock at a good price” cliché does not work in this arena and never did.
In my experience, most money managers do not understand the complexities of options and like most of us, fear what they cannot understand. If they did, more equity managers would have used them over the last few decades as part of their strategies.
There are some interesting covered call ETFs available. In my experience, the strategy works best on highly volatile sectors and stocks, usually using strike prices above the current price of the security and where the expiration date is not too far in the future. BMO has a portfolio of such interesting ETFs. The BMO Covered Call Energy ETF (ZWEN) and BMO Covered Call Technology ETF (ZWT) should be entertained.
Tom Czitron is a former portfolio manager with more than four decades of investment experience, particularly in fixed income and asset mix strategy. He is a former lead manager of Royal Bank of Canada’s main bond fund.
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