Investment Road Test: RBS Covered Call Instalments

PORTFOLIO POINT: These instalments should add value when growth is slow and outperform in the event of a severe market downturn, when compared to holding stocks outright.

Now that we are four years into a savage bear market with no respite in sight (ambitious sell-side brokers are telling us to buy shares now, but try telling that to struggling investors suffering under constantly sideways or declining markets), analysts keep returning to the problematic concept known as the equity risk premium.

To recap, the equity risk premium is the expected higher return from shares that is thought to compensate investors for the risk of ranking last in the pecking order when corporate profits are divided up.

Since all other forms of corporate finance involve set costs, shares get whatever else is left over after debt and preference equity has been paid off. That means that when corporate profits rise, the excess is paid to ordinary shareholders, and the prospect of rising income streams (dividends) drives up the share price. Or so it’s meant to, for as share investors are experiencing in today’s bizarre markets, even stocks with growing revenues are struggling to keep their share price above water. Today’s risk-averse investors are unable to justify paying higher prices for shares, given their worries about risks going forward.

It’s no wonder that income investing is back in vogue, with high-yielding hybrids setting the scene for investors over the last 12 months. In these conditions, overwriting shares by selling call options to enhance their return is considered to be an orthodox strategy, and RBS has launched an innovative new “buy/write” instalment product that makes this otherwise complicated strategy available to retail investors.

Mindful of the shock revelation last week from JPMorgan, which incurred a $2 billion trading loss from complex derivatives known as “synthetic credit” (the same products that started the GFC), it’s important to be very careful when advocating derivative-based strategies for retail investors.

Thankfully, covered call writing is a simple concept which involves preset and determinable levels of risk.

Here is a quick primer of the strategy (sometimes known as the “buy/write” approach):

• The investor buys or already holds shares in company X;
• Assume that company X has a share price today of $10 and a dividend of $0.50 (e.g. a yield of 5% p.a.);
• The investor sells a call option over company X shares with an exercise price of $11, a term of one year, and in return receives $1 income for selling that call option;
• If company X share price stays below $11 for the term of the call option, at the end of that year, the call option lapses (e.g. it expires worthless);
• Or, if company X’s share price is above $11 at the maturity date of the call option, the investor is forced to sell the company X shares for a price of $11.

A call option is a contract giving the buyer the right (but not the obligation) to buy the share from the seller of the call option, for the agreed exercise price of the option. The worst that can happen for the seller of the call is that he/she is forced to sell the stock at the maturity date of the call option for a price which is below the share price prevailing at that time. Even so, the price the share is sold at will be higher than the price of the share when the call option was originally sold. So the seller of the call option makes money by receiving the initial payment of income from selling the call option (known as the option “premium”) and also makes profit by selling the stock at the maturity of the call option. The downside in this scenario is simply the foregone additional profit that could have been created had the investor been able to sell their shares at the higher price prevailing at the maturity date.

(The “covered call” strategy is just that – it relies on having enough shares on hand to cover the sold call options. This is to be distinguished from the far riskier strategy known as “naked” option selling, where the investor doesn’t hedge their sold option position, implying far higher potential risk of loss if the option is exercised).

The core benefit of the covered call strategy is the ability to generate additional levels of income over shares: in the example above, the investor has boosted the income yield from 5% to 15%. One of the easiest ways to understand this phenomenon is to consider it as a way of pre-selling some of the future capital gain on a stock. It’s an even nicer outcome if the stock price doesn’t rise above the exercise price of the call option, in which case it’s like being paid for a future capital gain that ultimately never arises. Looked at another way, selling call options over shares which are already held or have just been purchased is like an insurance contract, for the income received in effect is a subsidy for the cost of the share. In this example, the $1 option premium can also be considered as lowering the purchase price of the share by $1.

The problem for retail investors is that options broking can be expensive to implement (with far higher brokerage costs than normal share broking) as well as involving complex concepts and an often opaque market. Enter investments like RBS “buy/write” instalments. Using a real life example over NAB shares, we can see the opportunities for income enhancement using the RBS buy/write instalments. In this example:

• the instalment embeds a 70% limited recourse loan to help magnify the investor’s return;
• the investor pays some interest on that loan (in this case at the rate of 7.43% p.a.) and should be entitled to a tax deduction for that expense;
• the issuer (RBS) hedges its loan by embedding protection within the instalment, in this case a “put” option with an exercise price calculated at 70% of the share price;
• the investor sells a call option with an exercise price of 115% of the share price (e.g. the “covered call”);
• the investor is therefore in the position of holding a NAB share, with a sold call option and a loan, with the loan being secured by the purchase of a put option;
• during the term of the instalment, the NAB shares are expected to pay three dividends, and as the holder of the share, the investor receives those dividends and any attached franking credits;
• the ASX code for this instalment is NABIRC and has an expiry date of 27 June 2013. RBS offers a wide range of underlying stocks for these “buy/write” instalments:

In this example, the attraction of the covered call strategy is enhanced by the leveraged potential for an enhanced capital gain of 68.01%, compared to the risk of loss of interest expense and the capital contributed to the position. In the scenario where the underlying stock rises by 15% or more during the term, the investor’s capital gain is capped at the maximum of 15% (i.e. $6.03), such that for the initial outlay of $8.87 (which includes the investor’s interest, as well as their contribution of 30% of the total capital cost of the position), the maximum return on investment is 68.01%. Smaller gains will create lower rates of return, with the worst-case scenario being that the investor could lose the total outlay if NAB shares fall by 30% or more during the term.

Three important points should be noticed here:
1. The potential loss to the investor is less than would arise if the NAB shares were purchased outright (e.g. with no borrowing and no protection, the loss would be larger than can arise if the buy/write instalment is used, because the instalment contains protection against the share price falling by more than 70%);
2. Unlike a range of similar instalment products (which rely on the far riskier “stop loss” protection mechanism), the embedded protection in the RBS buy/write instalment uses physical put options, which stay in place for the term of the product and provide maximum certainty for the investor’s benefit;
3. Just as the potential for gain if the share price rises is magnified by the use of leverage, it also needs to be noted that losses of capital (if the share price falls) will also be magnified as a percentage of capital deployed.

The RBS “buy/write” instalments access lending at an attractive interest rate of 7.43% p.a. and through the protection mechanism, this loan does not involve margin calls. (It should be said again that these and similar types of products were available before the GFC, exposing advisers like Storm Financial, which ignored the lower risk potential these products provide, contributing to clients’ massive losses incurred by margin lending in declining markets).

Covered call strategies are also highly regarded in the academic literature. Top finance academic Professor Tony Hall (Head of the Finance department at UTS) and his team reported in 2004 that:
“'¦covered call strategies have the effect of enhancing the average return of the portfolio, reducing the standard deviation of returns and improving the risk-adjusted returns of the balanced portfolio.”

When leverage is used in combination with buy/write strategies, volatility and risk is added back into the portfolio (compared to the ungeared alternative). But using gearing with embedded protection can largely overcome the increased volatility as well as reducing overall risk. Looked at simply, the additional yield which can be created using covered call writing can be seen as a way to create cash flow to defray gearing costs (as well as the costs of protection built into instalment-style gearing). In a flat-to-slow-growth environment, the RBS buy/write instalments can add value to the investment portfolio, and the embedded protection should give a better result in the event of a severe market downturn, compared to owning stocks outright. The tax profile of these types of instalments is far superior to some of the synthetic gearing products we have reviewed recently; interest costs should be deductible but any gain on sale of these instalments should be subject to concessional CGT treatment (assuming an investment period of 12 months or more).

1.0 Ease of understanding/transparency
0.5 Fees
1.0 Performance/durability/volatility/relevance of underlying asset
1.0 Regulatory profile/risks
0.5 Innovation

The score: RBS Covered Call Instalments – 4.0 stars
1.0 Ease of understanding/transparency
0.5 Fees
1.0 Performance/durability/volatility/relevance of underlying asset
1.0 Regulatory profile/risks
0.5 Innovation

Tony Rumble is the founder of the ASX-listed products course LPAC Online. He provides consulting and financial product services but does not receive any benefit in relation to the product reviewed.