Exploring the hidden risks of high-yielding products

Thanks to John Heinzl for quoting me in his recent piece Exploring the hidden risks of high-yielding products:

Covered call writing may work well in flat or falling markets, but in general it does more harm than good, critics say.

“I consider the … strategy to be a gimmick to snare the unwary,” James Hymas, president of Hymas Investment Management Inc., said in an e-mail. “I have never seen any evidence whatsoever that any single one of these covered call enthusiasts are any good at writing and trading options. And if you’re not good at it you will give up more in foregone capital gains than you gain in option premia.”

In contrast, split preferred dividends are generally safe. In FTN.PR.A’s case, however, there’s an added wrinkle: The manager, Quadravest Capital Management Inc., has hiked the dividend on the preferreds three times in the past four years, by a cumulative 68 per cent. That’s an enormous increase, and it’s the reason the preferreds now yield north of 9 per cent, based on annualizing the most recent monthly dividend.

“I believe that Quadravest boosted the preferred share dividend to such a high level because they wanted to keep the preferred share price high” to facilitate the sale of additional shares through the company’s “at-the-market equity program,” Mr. Hymas said. The ATM, which the company renewed in December, allows Financial 15 Split to issue shares to the public from time to time at the company’s discretion.

But here’s the thing: The dividend – which is currently about 7.7 cents a month or 92.5 cents annually – won’t necessarily remain at its current level forever. The dividend rate is set annually at the discretion of the board and is subject only to a minimum yield of 5.5 per cent until 2025, when the split corporation is scheduled for termination on Dec. 1 of that year (subject to a further five-year extension).

If Quadravest were to cut the preferred dividend to the minimum of 5.5 per cent (based on the issue price of $10) in December, 2024, investors who hold the shares from now until maturity in December, 2025, would have an effective annual yield of just 6.75 per cent, Mr. Hymas said.

One Response to “Exploring the hidden risks of high-yielding products”

  1. Tim says:

    Regarding using call option writing as an income strategy for funds, this is making a long-term bet with some big factors against you.

    1. For equities, the long-term direction for unit prices is up, so if you continually bet they will stay the same or fall, that’s a headwind. If your market does go up (as it did in 2023), you are structurally set up to lose because your option is certain to be called.

    2. You have to recoup the cost of writing the options and the trading costs of the options.

    3. You have to be continually successful at predicting when to initially sell the calls, what to price them at, and what expiration dates to pick, thus lots of active management and continuous reliance on being right at all of these, over and over (thus relying on luck).

    4. As identified in the article, the universe of liquid Canadian options is smaller than the overall Canadian market so there are fewer primary issues available to you as a fund manager. In this specific case, HMAX is already only targeting Canadian financials so a small subset of a small subset.

    Like the continual drag of costs if implementing currency hedging, the drag of option writing costs and the active management decisions that go against you are really hard to overcome with the gain of the option income over a longer period of time.


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