Richard Croft, President and Chief Investment Officer, RN Croft Financial Group

FOCUS: Options & ETFs

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MARKET OUTLOOK:

Having laid out a thesis that markets are not overvalued does not imply one should hold a portfolio of 100 per cent equities. A portfolio must include a balance of equity and fixed income assets where the weighting applied to each asset class reflects the objectives and risk tolerance of the investor. The challenge in my mind is holding fixed income assets in an environment where interest rates are expected to rise.

When you think about bonds understand that the price of the bond floats while the interest rate remains fixed. When rates rise, the value of the bond declines and the longer the term to maturity the greater the impact that has on the price of the bond. From my perspective, bonds may well be the highest risk asset within a portfolio. One way around this is to look for bond alternatives such as preferred shares and good quality real estate investment trusts. 

I am suggesting good quality preferred shares as a fixed income substitute because I believe they are undervalued relative to bonds. Prior to the financial crisis good quality preferred shares (rated P1 or P2) typically traded at a yield that was 80 per cent of the yield on the same company’s ten year corporate bonds. The yield differential reflected the tax advantages of earning dividend income versus interest income. In short, the after-tax yield in a non-registered account from a preferred share was slightly higher than the after- tax yield on the company’s corporate bonds. And prior to the financial crisis most market participants believed that good quality preferred shares were not that much riskier than the bonds on the same company.

The financial crisis changed all that. Many good quality U.S. preferred shares stopped paying dividends because management could do so without fear of plunging their company into bankruptcy. While the interest payments on bonds are mandated through the bond’s indenture no such protection exists for preferred shareholders. Unfortunately, many Canadian preferred shares got painted with the same brush though most continued to pay dividends throughout the financial crisis. The result, Canadian preferred shares are currently yielding about 120 per cent of the yield payable on the company’s ten year corporate bonds. That change in valuation makes these instruments an excellent alternative to bonds.

If you want further protection, consider buying so-called reset preferred shares where the dividend is adjusted based on either the prime rate or the current rate payable on government bonds. With interest rates expected to rise, these preferred share payouts will increase which will support their price. One security you might consider is the iShares Canadian Preferred Share Index ETF (CPD.TO recent price $14.00) which is over-weighted in reset preferred shares. CPD also pays a monthly distribution of 5.122 cents per share which yields 4.554 per cent.

In terms of real estate investment trusts (REIT), I prefer to focus on quality which leads me to the RioCan REIT (REI.UN.TO recent price: $25.77). RioCan pays a monthly distribution equal to 11.75 cents per share for a yield of 5.435 per cent and has options which could be sold to enhance the cash flow from this asset.  

Top Picks:

ADVANCED MICRO DEVICES (AMD.O) COVERED CALL

Buy AMD common shares: US$10.39

Sell AMD Oct 10 calls: US$1.79

Net per share cost of position US$8.60

Potential Outcomes on six month returns

• Return if Exercised: 16.28%
• Return if Unchanged: 16.28%
• Downside Break even: US$8.40

AMD was the beneficiary of sentiment, fickle as that may be. Excitement over AMD’s new line of chips provided a great storyline which works until the ultimate release and testing by independent sources. Reality quickly set in couple with lower margins in their latest quarterly earnings, and voila, market efficiency punished shareholders with a serious sell-off and a major expansion of option premiums. This is a strategy that is intended to take advantage of the premium expansion if you are of the view that AMD is now trading at a reasonable level unencumbered by animal spirits.

SQUARE INC. (SQ.N) COVERED CALL

Buy SQ common shares: US$20.10

Sell SQ Sept 21 calls: US$1.30

Net per share cost of position: US$18.80

Potential Outcomes on five month Returns

• Return if Exercised:11.70%
• Return if Unchanged: 6.91%
• Downside Break even: $18.80

Square Inc. (SQ) is a financial services company that provides payment processing for small business as well as lines of credit. Strong growth and significant upside potential if the US economy performance as expected.

DEUTSCHE BANK AG (DB.N) - COVERED CALL

Buy DB common shares: US$18.47

Sell DB Oct 19 calls: US$1.25

Net per share cost of position: US$17.22

Potential Outcomes on six month returns

• Return if Exercised: 10.34%
• Return if Unchanged: 9.99%
• Downside Break even: $17.22

Deutsche Bank (DB) recently completed a “rights” offering which re-capitalized the company. I like the prospects for a revitalized bank and with expectations that European market may outpace US stocks, DB should do well over the next year.

Past Picks:

Bank of America 

Long Jan 25 calls: Credit $1.38 , Debit $2.12, Profit (Loss) $0.74 
Short Jan 25 puts: Credit $4.35, Debit $2.70, Profit (Loss) $1.65
Net Per Share Proft (Loss): Credit $5.73, Debit $4.82, Profit (Loss) $0.91

Morgan Stanley

Long Jan 45 calls: Credit $2.82, Debit $4.90, Profit (Loss) $2.08
Short Jan 45 puts: Credit $6.75, Debit $4.85, Profit (Loss) $1.90
Net Per Share Profit (Loss): Credit $9.57, Debit $9.75, Profit (Loss) $0.18

Percent: -1.85%

Royal Bank of Canada

Long Jan 90 calls:Credit $4.50, Debit $5.90, Profit (Loss) $1.40

Percent: 31.11%

Total Return Average: +16.04%

Fund Profile: CFG Custom Portfolio Corporation, Option Writing

Performance as of: March 31, 2017

• 1 month: Fund 1.48%, Index* 1.09%
• 6 month:Fund 10.49%, Index* 4.44%
• 1 year:Fund 19.22%, Index* 11.71%

* Index: MX Covered Call Index

Company Website: www.croftgroup.com

Blog: www.optionmatters.ca