PM Corner: In conversation with Hamilton Reiner
Equity Premium Income’s Hamilton Reiner delves into the power of alternative income strategies in an income-hungry world.
Typically, we think of a bond as a risk-free return asset, but these days it feels more like a return-free risk asset.
Q: Hamilton, when investors search for ways to generate income in such tough market conditions what are they missing?
Ever since the Federal Reserve flooded the market with liquidity, keeping interest rates lower for longer, there has been a perennial problem of finding income. While inflation has been running hotter than normal in recent months, real yields are now less than zero. With the 10-year U.S. Treasury yielding about 1.5%, it’s a very challenging time to generate income.
Typically, we think of a bond as a risk-free return asset, but these days it feels more like a return-free risk asset. Investors have largely used fixed income for its negative correlation to equities, but today’s bond yields are far from inspiring.
Q: How can we get sufficient yield to meet investors’ income needs?
We have to be creative. One good way to generate income is through an equity options-based solution comprising a high quality equity portfolio and selling S&P 500 call options. Our Equity Premium Income strategy generates income by selling options and investing in U.S. large cap stocks, seeking to deliver a monthly income stream from associated option premiums and stock dividends. Remember, income is hard to find, particularly with reduced volatility vs. the S&P 500, no leverage, and daily liquidity. There is one basic trade-off inherent in an equity options-based solution: giving away some of the stock market upside for a consistent income stream.
Q: How do you put an equity premium income-type product to work? What roles does it serve in a portfolio?
I see three main use cases for an equity premium income-type strategy. First, if you have an income model, a modest allocation can act as a “booster shot” to income.
Second, we are seeing people use this type of strategy as an equity alternative, with reduced equity beta vs. the S&P 500. Total returns can be received through dividends, options premium, and some of the market’s upside over time. However, you will forgo some of the upside for potentially higher levels of income. With an equity options-based solution, you can receive above average levels of income with reduced volatility.
Third, as people are less enamored by low bond yield levels and tight credit spreads, we see clients using these strategies to replace high yield, emerging market debt, or U.S. preferreds, receiving potentially more income with similar levels of beta.
Q: How do you think about the liquidity profile of different income-yielding assets today?
A conundrum for many investors is finding an asset that delivers high yield and liquidity. To boost income, we see many clients diving into the deep end and employing higher volatility assets like MLPs, direct lending, or private assets. Not only do these assets have significant volatility, they also tend to have low liquidity. We need to balance risk, return, and income, and get all three right over time.
High quality stocks can act as an implicit buffer to the downside. More defensive equities can help because when markets go down, a high quality, low volatility equity portfolio is likely to fare better.
Q: How do you think about the equity market risk of different income-yielding assets?
We look at yield vs. beta to the S&P 500. High yield, emerging market debt, and U.S. preferreds typically have about 0.45-0.5 beta to the S&P 500. In other words, owning these assets means taking on equity market risk. If you’re going to take on this risk and seek income, think about how much income per unit of risk you’re looking for.
What we’re seeing today is that equity options-based strategies that generate income have the ability to capture more income than assets like high yield, emerging market debt, or U.S. preferreds – in some cases, over double the amount of income, without taking on much more risk in order to do so.
Q: How does this type of strategy perform in downside scenarios?
We aim for an underlying equity portfolio that is more conservative in nature, with less market beta and volatility. High quality stocks can act as an implicit buffer to the downside. More defensive equities can help because when markets go down, a high quality, low volatility equity portfolio is likely to fare better.
Q: How do you generate significant levels of income with a defensive equity portfolio?
One way is by selling one-month, out-of-the-money S&P 500 Index call options, overlaid on top of a defensive equity portfolio. Then you can receive income from dividends on the equities, and also from selling the options. When you sell out-of-the-money call options, you may give up some of the market upside but may maintain consistent long-term performance.
With other covered call strategies that sell single security options, investors often see stock winners taken away and then they’re stuck with the stock losers. We want to keep our equities, so we sell options on the index. Another differentiator is converting the options premium into coupon, which means you will not have return of capital. Many covered call strategies treat their options income as capital gains, which leaves the potential for return of capital. At the end of the year, investors then need to go back and recalculate the cost basis of their holdings, which is a burdensome process. I believe treating the options income as coupon is a better approach because it sets up the potential for monthly distributable income without return of capital.
Q: When you sell call options to generate income, how does volatility affect the strategy? Do you actively manage the strategy based on changing volatility?
We follow a consistent approach without trying to time the market. Selling one-month call options, and laddering the options each week, allows us to adjust how much upside and income we can receive in differing volatility environments. When volatility goes up, options tend to get more expensive. Because we are selling options, they are more attractively valued. So we have a chance to have our cake and eat it, too. In other words, we have the potential for more market upside and more income. Especially in the current investment environment, that’s a very attractive combination.