PARTNER INSIGHT: The sudden recognition that markets were potentially complacent about inflation has resulted in an abrupt change in markets' expected volatility. BMO Global Asset Management believes this has unlocked an opportunity to access increased yields.
Investors have been repricing equities for a faster tightening path by the Federal Reserve, which led to a correction across the overheated global equity market at the beginning of February. The revived inflationary threats and the possibility of higher rates that could erode corporate profitability have resulted in a burst of volatility. We expect the higher volatility to revert to its long-term average (15%) as the backdrop of synchronised economic growth and strong corporate earnings remain supportive for equities. However, we anticipate further bursts of volatility throughout 2018 amid higher market sensitivity to inflation.
Looking ahead, if you are seeking income but also want to manage your exposure to these potential bursts of volatility, a covered call strategy could well be worth considering.
A covered call strategy managed by BMO Global Asset Management distributes a continuous stream of income from writing call options on the underlying index - S&P 500 Index for US equities, FTSE 100 Index for UK equities and Euro Stoxx 50 Index for eurozone equities. Overall, this strategy provides an option yield, ranging between 2 to 4%, on top of the dividend yield. Our strategy is likely to benefit further in 2018 as higher volatility implies that writing covered calls will become more lucrative from increased premiums.
Market downturns increase the volatility that the market participants are expecting (i.e. implied volatility). As a rule of thumb, when implied volatility increases, call premium increases and vice versa. If the volatility level settles at its long-term average, the annualised option yield will increase from a target of 2% per annum in the previous low volatility (10%) environment, to around 3% per annum in the UK, US and Europe.
Source: BMO Global Asset Management, Bloomberg, dividend yield as at 12.03.18.
Overall, the defensive nature of the strategy can be used as an alternative to ‘low volatility' and ‘high dividend yield' equity factor investing, or as a good complement to ‘riskier' conviction investments, as it can improve the risk-adjusted return of the overall portfolio. In addition, the cash flows received from option premiums do not have duration (price sensitivity to changes in interest rates) or credit risks, which make the strategy an efficient diversifier to fixed income investments.
The value of investments and any income derived from them can go down as well as up as a result of market or currency movements and investors may not get back the original amount invested. Shares purchased on the secondary market cannot usually be sold directly back to the Fund. Secondary market investors must buy and sell ETF Shares with the assistance of an intermediary (e.g. a stockbroker) and may incur fees for doing so. In addition, investors may pay more than the current Net Asset Value per Share when buying ETF Shares and may receive less than the current Net Asset Value per Share when selling them. Views and opinions have been arrived at by BMO Global Asset Management and should not be considered to be a recommendation or solicitation to buy or sell any products that may be mentioned.
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