With Interest Rates this low, Should Investors Look to Equity Dividend Yields?

Interest rates have moved lower recently due primarily to the financial scare across Europe.  The two-year Treasury is yielding a paltry 87 bps.  Even out 10 years, Treasuries are yielding about 3.25%.  What is an income investor to do?  Well, the recent sell-off in equities, accompanied by the expansion of implied volatility, has presented some interesting dividend yield plays.

Let’s take Conoco-Phillips (NYSE: COP) as an example:  The stock is trading at $50.50, and the company is currently paying out $2.20 per year in dividends.   That is an annual dividend yield of 4.35%, far outpacing the yield of the two-year treasury.  If you theoretically couple this with selling long-dated calls, things get really interesting.  Assuming that COP keeps its payout steady at $0.55 per quarter, investors could buy the stock for $50.50, sell the November 55 calls for $2.25, and collect two $0.55 dividends.  Let’s look at the cash flows assuming the stock does not move:

• Collect $1.10 in dividends
• Collect $2.25 in option premium
• Return is $3.35/$50.50 = 6.6% for about half a year.  That is an annualized rate of more than 13%.  This seems pretty good if you look at Treasury rates over that same time frame.

If the stock rallies, returns will be better.

Now, what about the risks:

• Stock declines:  if COP stock goes down, you could lose your entire investment.  Below $47.15, your entire position will actually yield a negative return.  Also, please remember that theoretically the stock price will decline by the amount of the dividend paid out.  Theoretically, COP should trade at $49.40 if all else is equal after its second dividend payment.
• Change in dividend policy:  If oil prices were to decline precipitously, or COP had a company-specific event, the company could lower or discontinue its dividend policy.  If the event was really adverse, you would probably see this change in policy in addition to a price decline in the stock.
• Change in timing of dividends:  if the company delays a dividend past the expiration of the call options, customers may have to roll their buy-write, and/or take off the trade without that benefit.
• Early Exercise:  If the calls are in-the-money right before the ex-div date, the calls the investor shorted may be assigned.  The stock would be called away, and there would be no dividend.  However, if this was the case, the benefits probably outweigh the cost.  That means the stock would have rallied more than10% to get through the strike.  Money would be made, just in a different fashion.

Overall, this strategy of doing buy-writes in higher yielding stocks is worth considering if investors have stocks they feel comfortable investing in, since there is risk in a downside price move.  It is interesting to evaluate these now because relative to fixed income, the pricing has changed greatly over the last month.  Rates are down and so are stock prices, which create higher dividend yields.

Here is a list of stocks and their potential annual dividend yields to evaluate.  Please note that the dividends may have changed and the stock prices may have moved since I compiled this list. You will want to check the math and the anticipated ex-dividend dates before considering any of the following names:

• Verizon Communications (NYSE: VZ), 6.9%
• AT&T Inc. (NYSE: T), 6.88%
• Duke Energy Corporation (NYSE: DUK), 6.01%
• Eli Lilly & Co. (NYSE: LLY), 5.9%
• American Electric Power Company (NYSE: AEP), 5.39%
• Du Pont de Nemours & Company (NYSE: DD), 4.63%
• FPL Group, Inc. (NYSE: FPL), 3.98%
• The Coca-Cola Company (NYSE: KO), 3.42%
• McDonald’s Corporation (NYSE: MCD), 3.25%
• The Procter & Gamble Company (NYSE: PG), 3.14 %
• PepsiCo, Inc. (NYSE: PEP), 3.03%

Photo Credit: theakshay

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