c5327ff0-7087-4959-af57-4acea2fdb87e

Current Interest Rates

The Federal Reserve has begun lowering short-term interest rates, as expected.  They started with a 1/2 percent cut and are expected to continue to lower rates through 2025.  Longer-term rates went lower in anticipation of these cuts, but have since gone higher. 

The 10 year US Note had gone below 3.65%, but is now sitting at 4.21%.  This can be attributed to stronger than expected economic data and concerns that neither candidate in next month’s presidential election seems concerned about the federal deficit or debt.

Looking at the data below makes me think that the best value right now is in intermediate and longer-term municipal bonds.  Interest from municipal bonds are typically free from federal taxes.  In almost all states, if you buy bonds in the state that you live, that interest is also not taxed.  I used a 30% total tax rate for the comparisons below, 24% Federal and 6% State.  The higher your income and tax rate, the more valuable that interest free income is worth.

 

Interest Rates That You Receive

1 Year5 Years10 Years20+ Years
US Government Bonds4.30%
4.07%4.21%4.62%
High Quality Municipal Bonds3.05%3.50%4.15%4.5%
Municipal Bonds- Tax Equivalent4.36%5.00%5.92%6.43%
CDs4.10%3.90%4.05%N/A
High Quality Corporate Bonds4.50%5.00%5.30%5.60%

Interest and Dividends From Funds

High Yield Corporate Bond Fund6.65%
Preferred Stock Fund6.07%
High Quality Dividend Stocks4.25%

Interest Rates That You Have to Pay

30 Year Mortgage6.75%
15 Year Mortgage6.00%
Credit Card APR23.37%

Current Stock Market Valuations

Stock market indexes have had a tremendous run since the lows of October 2022.  The S&P 500 has gained around 60% in less than two years.  The annualized return since that low has been an astonishing 28.5%, far outpacing the historical gain of about 10% per year.   If these returns were the norm, I would have a very easy job. 

The Price/Earnings Ratio, or PE ratio, tells you how much you are paying for each dollar of earnings of a stock or stock market index.  The current PE ratio for expected earnings of the S&P for the next year is about 21.  The chart below shows where that falls over the past 10 years.  We are 8.2% over the five-year average and 17.3% over the ten-year average. 

To justify a higher earnings multiple, one of two things have to happen: 

Option 1 is that companies grow their earnings at a greater pace than normal. Earnings growth for the S&P is projected to be 16% by the end of 2025.  Those are lofty expectations as the historical average is around 10%.  A lot of earnings growth is expected from the adoption of Artificial Intelligence, so this very well may happen. 

Option 2 is that the stock market will have subpar returns over the intermediate future.  Currently, the market is justifying its higher than average Price/Earnings ratio because of that higher than expected earnings growth.

I’m not necessarily calling for a stock market crash, but I am being a little cautious.  Long-term time horizons smooth out risk.  Selling out of stocks now with the idea of buying them back at a cheaper price is usually a loser’s game.  Selling appreciated assets also creates capital gains.  Many clients have significant capital gains.  It simply doesn’t make sense to sell your holdings and pay taxes, hoping to buy them back a little lower.  August through October is on average the weakest stretch of the year. That being said, I am taking my time with any new money or cash coming from bonds that normally would be allocated to stocks.  Rest assured, your allocations will soon be where they need to be.  With risk-free government bonds paying around 5%, I just may take some extra getting there.

The Case for Individual Bonds

Exchange Traded Funds (ETFs) are fantastic investment products that provide diversification at a relative low cost to investors.  These funds can hold stocks, bonds, real estate, gold, or about any kind of investment you can think of.  I use them for my clients and myself.  However, when it comes to fixed income products there are some important reasons to consider using high grade individual bonds and CDs for your portfolio.

Predictability:

When you buy an individual bond, you know much you’re paying for it, how much it’s paying you, and how much you will receive when the bond is due.  A steady stream of income can be created from several different individual bonds.  This predictability can be particularly valuable for retirees relying on bond income to cover living expenses. 

It is also helpful when you know a large expenditure is coming.  Whether that is buying a house, paying for college, or any large ticket item, individual bonds can take the guess work out of returns.  For example, you can buy a US Government Treasury or CD that comes due right before the date that you need the funds

Less Volatility:

Most bond funds have a target duration or time frame that they want to hold bonds.  For example, the fund may target bonds that come due in about 10 years.  To achieve is, they will usually own a collection of bonds that have 8 to 12 years until they are due.  As time goes by and a bond has less than 8 years left, it will be sold and replaced by a bond that has 10-12 years left.  They then go out and buy the best bonds for their fund.  They are at the mercy of where current interest rates are at the time. This can lead to more inconsistent returns. Most bonds funds that aren’t very short-term funds don’t hold any bonds to maturity.  This isn’t a criticism.  It’s just how those funds work.

The strategy of using individual fixed income products works best using Certificates of Deposit or very high grade bonds, such as United States Government Treasuries and highly rated Municipal and Corporate Bonds.  This greatly reduces risk of default.  When it comes to lower grade and higher yield bonds, diversifying is very important.  That’s why I do use ETFs for higher yield bonds.  That’s when it’s better to pay them a small fee to own hundreds, or thousands, of different bonds from different issuers.

Avoiding Fund Fees and Expenses:

Bond funds typically charge management fees and expenses, which can erode investors’ returns over time. Most of the bond ETFs that I use charge very low fees, but they can add up over the long term, especially in periods of lower interest rates or market volatility. By investing in individual bonds, investors can bypass these fees and improve their overall returns.

Conclusion:

Building a fixed income portfolio is like putting together a puzzle. How much income is needed? How will this income be taxed?  How much risk should I take?  Diversification provided by ETFs is integral, but allocating at least some of your portfolio to individual bonds will take out some of the guesswork when you’re trying to solve your income needs.

Generating Income with Covered Calls

As a financial advisor, I am always looking for ways to generate more income for my clients’ portfolios.  Bonds can be great income producing products and are usually quite stable.  The downside of bonds is that they don’t give investors any upside appreciation.  One investment strategy that can give you both growth and income is called a covered call strategy.   Trading options may sound intimidating, but they can be used to cut risk and to generate income in your portfolio.

What is a Covered Call?

A covered call is an options strategy where an investor owns an asset, typically shares of a stock, and sells a call option on that same asset. The call option gives the buyer the right to purchase the underlying asset at a predetermined price within a specified period. In return for selling this call option, the investor receives a premium, which they keep regardless of what happens with the option.

How Does it Work?

Let’s break down the covered call strategy with an example:

Apple stock is trading at $170.  You can sell an option to sell your Apple stock on July 19 for $175.  One option contract is 100 shares of stock.  You would receive $6.50 in premium from selling your option.  That gives you a 3.8% yield for 3 months.

PriceDollars
Buy 100 Shares of Apple17017,000
Sell 1 Contract- 175 Call 6.50650
3 Month Covered Call Yield3.8%

Possible Outcomes

If the price of Apple stock goes lower, your first 3.8% in losses is covered by the premium that you received from selling the option. 

If the price stays around $170, you will receive your 3.8% yield.  

If the stock rises to $175 or above, you may have to sell your shares at $175, even if the stock appreciates well above that $175 price.  Your total return would then be:

$5 appreciation on the stock (175-170) plus the $6.50 in option premium = $11.50.

That makes your 3 month return 6.8%.

Apple Stock Price at ExpirationPercentage MoveGain or Loss $Gain or Loss %
150-11.8%-13.5-7.9
160-5.9%-3.5-2.1
1700.0%+6.5+3.8
175+2.9%+11.5+6.8
185+8.8%11.5+6.8

What Happens after your Option Expires?

What happens after July 19 depends on where your Apple stock is trading as that date arrives.  If the stock remains below $175, you can choose to sell another option at a later date and continue to make this an income generator for your portfolio.  If the stock is trading above $175, you may have the option of buying back that option and rolling it to a further out date and/or price or you could simply sell your shares for $175 for a solid return.

Tax Considerations

Options are subject to the same holding period rules as other investments.  If options are held for more than a year, they are taxed at the long-term capital gains rate, 15%, or 20% for higher earners.  If options are held for less than a year, they are taxed as ordinary income.  There are some covered call funds that use Index Based Options that offer more advantageous tax rates.  They are typically taxed as 60% long-term and 40% short-term.  Covered calls are probably best used in retirement accounts due to their taxation, but also work just fine in taxable accounts.

The Downside of Covered Calls

Like with any other investment, there are risks and consequences to consider:

  1. Limited Upside: By selling a call option, you cap your potential upside if the stock price rises significantly above the strike price.
  2. Limited Downside Protection: In our example, you received a 3.8% yield. If your stock depreciates by more than 3.8%, you will lose money.  

How Can I Use Covered Calls?

This strategy can be used on individual stocks, indexes like the S&P 500, or Exchange Traded Funds (ETFs).  ETFs give you diversification of the underlying asset and, typically, monthly income.  Using individual stocks gives you less diversification but it can give you more options as to how far out in time and price you want to write your option.  This can be very effective for highly appreciated stock that you don’t want to sell for tax purposes, but would like to use to generate more income for your portfolio.

Writing covered calls is not meant to be a replacement for the equity portion of your portfolio, but it can be a great way to increase your income.  The income portion of your portfolio should have a diverse mix of income producing investments, especially as you move into retirement.

If you think that covered call strategies could fit into your portfolio or have any questions, please reach out to me at shawn@smrstrategic.com.

SMR Strategic Investments, LLC is a registered investment advisor. The content herein is provided for informational and educational purposes only and is not intended to be personalized investment advice nor a recommendation to purchase or sell any investment. Investment advice is only rendered to clients after obtaining all relevant information regarding the client’s unique financial situation. This content is derived from many sources, which are believed to be reliable, but not formally audited by SMR. Content is at a point in time and subject to change without notice. Content may include opinions and forward looking statements, which may not come to pass or may change with different company, investment, market and/or economic conditions. Please contact SMR with any questions you may have.