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Two Ways to Solve the Income Shortage Puzzle

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Selling covered calls means more income with less risk.

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Even though bond yields have been climbing, many income investors are stuck in the same old boat of not having adequate cash flow.
A New York Times article titled "Why Many Retirees Could Outlive a $1 Million Nest Egg" said:

"For people close to retirement, the problem is acute. The conventional financial advice is that the older you get, the more you should put into bonds, which are widely considered safer than stocks. But consider this bleak picture: A typical 65-year-old couple with $1 million in tax-free municipal bonds want to retire. They plan to withdraw 4% of their savings a year - a common, rule-of-thumb drawdown. But under current conditions, if they spend that $40,000 a year, adjusted for inflation, there is a 72 percent probability that they will run through their bond portfolio before they die."

In ETF land, the 12-month yield on the iShares S&P National AMT-Free Muni Bond (NYSEARCA:MUB) is just under 3%. That means someone with a 4% withdrawal rate is eroding their principal. Regardless of whether the income is tax-free or not, today's munibond yields are so depressed, the prudent retiree has no choice but to look elsewhere for higher income.

The 100% Stock Portfolio

To that end, some investors are betting everything they own on the stock market. This is the opposite extreme of the 100% bond portfolio example cited above. The thesis behind this strategy is that since stocks have easily outperformed bonds over long-periods of time (25 years or longer), an all-stock portfolio will solve everything. (See the Wall Street Journal piece titled, "The 100% Stock Solution.")

On paper, the 100% stock portfolio may look good. But in the real world, market declines of 40%-60% as we've experienced in our lifetime (see 2000-02 and 2008-09) can permanently disrupt even the best of investment plans. And that's why a 100% stock portfolio is probably best geared for those who can afford very large drawdowns, and who don't mind large swings in market volatility.

What about the narrowing gap between stock and bond yields?

The current yield on the SPDR S&P 500 (NYSEARCA:SPY) is at 1.95% versus 2.2% for 10-Year US Treasury bonds (INDEXCBOE:TNX). However, since market lows in 2009, stocks are up 139% whereas Treasury bonds are up just 10.75%. Using their hindsight bias, the "Cult of Equities" clan are now convinced that since equity yields are almost the same as bonds, stocks offer the same type of income but with more appreciation potential. And as a result, they've decided to take more risk by increasing their exposure to stocks.

A Better Strategy

A less extreme approach is what our ETF Income Mix Portfolio does. Each month we sell covered calls on ETFs that track a few different asset classes: stocks (NYSEARCA:DIA), gold (NYSEARCA:GLD), and US real estate investment trusts (NYSEARCA:VNQ).

By using this technique, not only are we able to collect dividends from the underlying ETFs, but we also generate income from the options. And in the case of gold, we are able to convert a dead asset that generates no dividends, into an incoming producing asset! Since the start of 2013, our Income Mix Portfolio has generated $4,520 or $753 per month, based upon a $100,000 all-ETF portfolio. Each month we tell readers the best combination of ETF covered call options to sell.

One final strategy for solving the income shortage puzzle, is to sell out of the money call and put options. This is definately a less conservative strategy compared to selling covered calls because you don't own the underlying ETFs. However, properly placed trades often result in call and put options that expire completely worthless, which is what we want.

Below is a recent example of a GLD income trade we did. My firm's May 1 ETF Weekly Pick on GLD options said the following:

"After meandering in the mid-teens over the past five months, gold volatility (^GVZ) has jumped to over 20. That's translated into higher call option premiums for the SPDR Gold Shares (GLD). We like selling the GLD May 2013 143 call options (GLD130524C00143000) for around $200 of monthly income. These options expire on May 23, 2013 and our goal will be to watch them expire worthless. Although GLD has rallied hard since its swoon toward $130, the YTD price trend is still down."

How did our GLD income trade work out?

Just as we expected, our GLD May 2013 143 call options expired worthless and we bagged the monthly income.

Summary

Although selling covered calls puts a collar or limit on any potential capital gains, the monthly cash flow we get helps us to achieve our primary investment objective: More income with less risk.

Editor's note: This story by Ron DeLegge originally appeared on ETFguide.com.

To read more from ETFguide, see:

Don't Get Duped by Gamed Corporate Earnings

Will QE Tapering Derail Gold's Recovery?


Why It Can Be Cheaper to Hedge Junk Bonds Than Treasuries Now
No positions in stocks mentioned.
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