2 Double-Digit High-Yielding ETFs I’m Buying

JamesBreyThe context In the current interest rate environment, finding meaningful yield is finally possible. The higher SOFR has pushed down the valuations especially for more value and duration heavy asset classes, rendering various income strategies attractive. Yet, while in nominal terms, the yields have indeed increased, if we expressed the yield in real terms (i.e., adjusting for the inflation rate), the overall story would not seem that enticing anymore. What this means is that investors have to still search around and in some instances go slightly up the risk curve to capture assets that provide tangible yields. At this moment, it is not difficult to find stocks that offer ~5% dividends, but when it comes to 8 – 10% yielders, the universe of potential choices narrows a lot, especially if junk bonds and really speculative instruments are excluded. The potential choice A one alternative that provides close to or slightly above 10% yield is the covered call strategy-based ETFs. The beauty of these products is that they distribute high current income streams in a fairly consistent fashion, while introducing some downside protection in case the market noise-dives. The underlying mechanics of how covered call ETFs work are the following: ETF goes long a certain index (which can be also a very liquid ETF) or replicates its long positions of a particular index such as the S&P 500 or the Nasdaq 100. Then a set of calls are sold so that the entire notional base of assets are fully exposed to the covered call dynamics. The collected premiums of the written calls are directly distributed to the unitholders. The returns stemming from the collected premiums add an extra layer of defense in case the underlying assets or index go down. However, the only major risk of this strategy is related to the foregone upside potential, since selling calls impose a ceiling as to how far the underlying assets can appreciate until each incremental increase in the price is fully transferred to the call option buyers. For investors, who apply an income-based portfolio approach, where the most important thing is to capture above average yields that are underpinned by relatively durable instruments, incurring this kind of an opportunity cost should not be a roadblocker. Two examples While there are many covered call ETFs out there, the following two are one of my favorites. First is the Global X S&P 500 Covered Call ETF (NYSEARCA:XYLD), which is a pure play covered call ETF that sells options using the S&P 500 index. As for most of the covered call ETFs, the entire asset base for XYLD is linked to covered calls, which implies that the only upside through a potential price appreciation is limited by the difference of market price and call strike price at the time when an option is sold. An aspect that is rather specific to XYLD is the selling of covered calls that are near or already at the money. This allows the ETF to produce higher income streams than any average covered call ETF that also bases its strategy on selling calls against the S&P 500. As a result of this, XYLD is able to offer 9.4% in yield with very minimal upside potential, making it a decent choice for income-based investors for whom the price appreciation component does not matter. Second is the Global X Nasdaq 100 Covered Call ETF (NASDAQ:QYLD), which is a well-known and large-size ETF that also employs a covered call strategy. The main difference from XYLD is that QYLD writes calls against the Nasdaq-100, while keeping the focus on calls that are at the money or very close to it. Also, option frequency wise, both ETFs stick to monthly strategy, thereby minimizing the risk of option illiquidity. However, the yield produced by QYLD is roughly 220 basis points above of what is offered by XYLD. The main reason here lies in the only meaningful difference that is between these two ETFs – i.e., QYLD’s exposure to the Nasdaq-100 and not the S&P 500 as in XYLD’s case. Since the Nasdaq-100 is inherently more volatile due to a combination of higher concentration in the tech segment and lower number of the underlying constituents, the relevant options are more expensive, which in turn drive the yield potential higher. Yet, the investors have to weigh this against the increased downside risk, which might take place in case the high growth and tech names get suddenly penalized or repriced to lower multiples. The bottom line Employing covered call strategies could benefit the income-seeking investor portfolio by not only introducing an additional element of a diversification, but also boosting the overall yield of the portfolio higher. By going long covered call ETFs such as XYLD and QYLD, investors can access very juicy yield without assuming unnecessary financial risk. In fact, through these covered call ETFs investors get exposed to market risk, which is partially decreased by the presence of pocketed premiums from selling the covered calls. Granted, the disadvantage of covered call ETFs lies in the opportunity cost that is associated with any returns from the price appreciation channel as the sold options create a ceiling as to how far the underlying assets can appreciate in value. For XYLD and QYLD the room for price appreciation is limited given the focus on ATM calls. However, for high income chasing investors the benefit of abnormal current income streams at relatively reduced risk can outweigh the drawback from the limited price appreciation potential. Finally, we all have to consider in this context the fact that the VIX, which measures the implied volatility of the S&P 500 (which is also largely reflective of the Nasdaq-100 dynamics) is currently trading at rather depressed levels. YCharts On a go forward basis, this implies a further opportunity for covered call ETFs to distribute more sizeable income streams once the volatility shoots higher from historically low levels.

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