Increasing Yield - Using a Covered Call Strategy to Enhance Bank Yield

Increasing Yield:
Using a Covered Call Strategy to Enhance Bank Yield

by Alfred Lee, CFA, DMS
Vice President & Investment Strategist
BMO ETFs & Global Structured Investments
BMO Asset Management
alfred.lee[at]bmo.com

March 31, 2011
Recent Developments:

• The stocks of the Big Six Canadian banks as a whole have experienced a good run after recently posting solid quarterly earnings. The S&P/TSX Canadian Banks Index, an Index that tracks the Canadian banks, recently broke above its pre-crisis high (Chart A). While this could be bullish for the group, a failure to hold above this level could potentially send the index lower. Its Relative Strength Index (RSI), a technical indicator, has moved slightly beyond a 70 reading, which tends to indicate that, near-term, it’s overbought. A Canadian bank covered call strategy can protect some of the downside protection, while still maintaining exposure to the Big-Six Canadian banks. For details and mechanics behind a covered call strategy, please see our paper Covered-Call Option Strategy on our homepage or click here.
• From a global viewpoint, Canadian banks have considerably outperformed their global peers as indicated by the relative strength (RS) of the S&P/TSX Canadian Banks Index vs. the FTSE Global Bank Index (Chart B). The ratio between the two indices remains very close to its 10-year highs. In our opinion, Canadian banks should be trading at a premium relative to their global peers given strong Tier-One capital ratios as a group and being ranked by the World Economic Forum as the most-sound banking system in the world. However, with a number of U.S. banks recently being granted approval by the U.S. Federal Reserve to raise dividends and initiate stock buy-back plans, the markets could see some rotation out of Canadian banks. As a result, some investors may want to look for some downside protection, even though the Canadian banks look strong fundamentally (Chart C).

Potential Investment Opportunity:

• Utilizing a covered-call strategy on the Canadian banks allows investors to retain exposure to Canadian banks while also maintaining some downside protection. Potential weakness in the performance of the stocks of Canadian banks will be partially offset by the premium earned selling call options. In addition to the underlying dividend yield of the banks, call option premiums collected will also enhance the overall yield of the strategy.
• Investors looking to execute this strategy may consider the BMO Covered Call Canadian Banks ETF (ZWB). A covered-call strategy is ideal for investors that are moderately bullish or believe the underlying banks will trade in a range bound pattern. Moreover, it is also a strategy for those investors that are looking to enhance income or yield.

Chart A: S&P/TSX Banks Index Breaks Above Pre-Crisis Highs

Source: Bloomberg, BMO Asset Management Inc.

Chart B: Canadian Banks Have Run Considerably Against Global Peers

Source: Bloomberg, BMO Asset Management Inc.

Chart C: Canadian Banks Showing Fundamentally Strength

Source: Bloomberg, BMO Asset Management Inc.

*All prices as of market close March 31, 2011 unless otherwise indicated.

Disclaimer:
Information, opinions and statistical data contained in this report were obtained or derived from sources deemed to be reliable, but BMO Asset Management Inc. does not represent that any such information, opinion or statistical data is accurate or complete and they should not be relied upon as such. Particular investments and/or trading strategies should be evaluated relative to each individual’s circumstances. Individuals should seek the advice of professionals, as appropriate, regarding any particular investment.

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