Income Report / Income Report; 2 extremes – Income from Hybrids & Options

By Market Matters 17 January 18

Income Report; 2 extremes – Income from Hybrids & Options

Market Matters Income Update 17th January 2018

Last week’s Income Report was timely with the market pulling back from our 6150 target that day to now trade at  6016 at time of writing. We increased cash marginally by reducing NAB by 4.5% and we now have cash sitting  at 7%. That number needs to be considered in combination with our allocation to Hybrids and Fixed Income which sits at 35%, leaving 58% exposed to equities. In terms of the MM Income Portfolio over the past week, it declined by -0.828% with Woodside, the banks, TLS and GMA having most negative influence, while on the positive side, Perpetual (PPT) – the currently unloved fund manager was our best performer.

ASX 200 Daily

Perpetual Daily Chart

The yield of the portfolio remains strong, above 7% grossed for franking and importantly, the yield in aggregate looks reasonably predictable and sustainable over the foreseeable future. Since inception (7th July 2017), the portfolio is up by ~7.85% which is strong given our reasonably low equity allocation, however it lags the Platinum Portfolio which is up by ~10.32% in the past ~6 months.  Markets though have been strong – which makes it easier – we earn our keep more so when markets become trickier which we expect over the next few years.

One of the interesting trends from an income perspective, has been the money flowing into the Hybrid space. This area of the market copped some heat from the outgoing ASIC Commissioner last year, along with some of the more vocal market commentators. The focus though seems to have had the opposite effect spurring interest in the space, and we’re seeing more institutional money in the area than ever before. To give some context around this, spreads back in April of 2016, the date we started tracking numbers on Hybrids closely, averaged 4.27% over the relevant bank bill rate, today the average of our hybrid universe is 2.65% the same rate  – a big move and clearly shows strong appetite for the asset class.

In simple terms, banks and other institutions were needing to offer a yield of 6.5/7% to raise tier 1 capital and now we see it closer to 5/5.5%. In terms of floating rate securities, they pay a rate over and above a bank bill rate, and the markets view of perceived risk (along with a few other factors) will dictate what that number is. Right now, given the market has a strong appetite for these securities, their prices have rallied on the market, compressing the overall yield.

Over 2017 and early 2018 there has been a void of new issues coming to market given that banks are reasonably well capitalised and corporate Australia is pretty much under geared, which means that demand for on-market notes is high, and any new issues are very well bid (hard to get).  The cautionary tale here though, and we have one very good example to highlight, is that things change in the market and spreads can blow out again. At sub 3% over swap it’s time to start being very picky in this area, and in time, we will likely use this strong demand to reduce our exposure.

The CBAPD which was issued by CBA in 2014, had an initial margin of 2.80% over the 90 day bank bill rate. At the time, demand for these securities was high, and CBA took advantage of it. Subsequently, demand for these securities declined, global credit markets got the jitters and the market demanded a higher yield to compensate for the risk of holding,  which caused a drop in price to below ~$86.00. Now, markets are once again comfortable and the notes have recovered nicely. The moral of the story is, markets are dynamic and actively managing hybrids and well as shares can improve returns and reduce risk – positive trends rarely persists unabated.

CBAPD Weekly Chart

How we use options across our investment accounts to generate income

Slightly off track today however I wrote an article for LiveWire early in January about how we use options within our portfolios. Obviously we don’t write about this regularly within MM given it can be reasonably complicated, however the below could serve as an appetizer for any subscriber interested in this area. You can certainly contact myself and the team at Shaw should you have any specific questions, or you would like to investigate further. As I suggested this morning, 2018 will be a year where expanding ones horizons could provide beneficial

We use derivatives across the majority of our portfolios to improve performance and / or to reduce portfolio volatility. They help us consistently beat the market over time and improve the overall flexibility within our portfolios. We are almost entirely ‘sellers’ of options, and the bulk of our transactions are done on the index. We’re not speculators, we do use options to hedge market (and stock risk) at times, however, the bulk of our positions are there to take advantage of time decay and to sell volatility (risk).

Think of options in terms of an insurance company

Selling time is pretty straightforward, however judging whether or not we’re getting paid enough to be on the short side of volatility (risk) is more difficult. A useful way to think about the use of options as an investor is to think about it in terms of an insurance company.

Typically, an individual will buy insurance to protect against an unlikely scenario becoming reality – something from left field. It provides some piece of mind and in some instances, useful cover.The insured event may play out in a short period of time and you’ll be thankful that you held insurance. What’s more ‘probable’ though is that it may take a number of years or simply not happen at all.

The likelihood is that the insured person has spent money on insurance that in hindsight has not been needed - after all, the event that has been covered is an ‘unlikely’ scenario from a statistical standpoint.An insurance company sits on the other side of that trade. They sell the policy at a price that they judge to be adequate compensation for 1: The time of the cover; and 2: The probability of the adverse event playing out.

Looking at my own monthly cost of insurance for house, vehicles, life, income protection, health, etc., I spend roughly $980 per month on insurance and on many occasions, have considered who has made the better trade here – me, or the insurance company? If we tie this back into using options, as an investor we have the choice of being the insurance company’s customer by buying protection, or instead being the insurance company itself, by selling protection. Nine times out of ten, we choose to be the insurance company by selling out-of-the-money index options.

Why Index Options rather than stock options?

Just like an insurance company, collecting money from one person and providing them cover is a lot riskier than having a broad spectrum of customers and collecting money from them all, knowing that statistically, some will get into some form of trouble. The same applies to the index versus singular stock options.

The probability that singular stocks have profit upgrades, downgrades, regulatory issues, management issues, etc., is quite high. On the other hand, if we think about the index, the 200 stocks that make up the ASX 200, by selling options against a basket of stocks, our exposure to each individual stock move is greatly reduced, which reduces the overall risk of the position. Furthermore, history will show that markets, for a greater proportion of time will gradually move higher, gradually move lower, or broadly track sideways. Of course, events happen and markets can and will have a sharp reaction to it, however by selling index options we’re simply playing the probability card, recognising that at some point we will give back some of the premium we have accrued over time.

Right now, volatility in markets is low and option premiums are reflective of that. All is calm, however having the ability to sell volatility when it kicks up, and importantly, benefit from the erosion of time in my view can greatly improve portfolio returns. The option strategy discussed above is known as a short strangle, and involves selling an out-of-the-money (OTM) call, and an out-of-the-money put simultaneously on the same underlying security, in the case above, the ASX 200 Index.

The strike prices can be determined by the seller based on risk preferences and income goals. For example, options with strike prices closer to at-the-money (ATM) yield greater premiums but have a higher probability of losing money. Conversely, options with strike prices that are further out-of-the-money have a lower premium yield but a greater chance of making money.

The next decision comes around time: how long to be exposed for? Shorter-dated options pay less and longer dated options pay more, however, time decay picks up more towards expiry. We are typically sellers of shorter-dated options for that reason

Conclusion (s)

We are conscious of the strong run up in the Hybrid market, and expect to use this strength to lock in profits, but not yet
Selling options can improve portfolio income

Disclosure

Market Matters may hold stocks mentioned in this report. Subscribers can view a full list of holdings on the website by clicking here. Positions are updated each Wednesday, or after the session when positions are traded.

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