Financials could yield rewards

What we know is that the Fed will raise interest rates at some point. The question of when determines the options strategy that would be most appropriate for your clients. If you are in the camp that believes that interest rates will not move until perhaps mid-2016, then a covered-call strategy would make sense. This will allow you to capture some income while you wait.

If you think the Fed will move sooner rather than later – say, December 2015 – then buying longer-term calls would be the strategy of choice. The idea here is to capture the upswing as the market reprices bank stocks to reflect stronger margins.

The other issue to look at is whether you think the metrics favour U.S. banks vs Canadian banks. That’s a tougher call. Most likely, U.S. banks would get more bang for their buck, assuming that loan growth continues at its current pace. On the other hand, Canadian banks have better yields. Note that Bank of Montreal and Bank of Nova Scotia both are yielding in excess of 4.5% a year.

There are some recent studies that suggest the U.S. economy may be performing better than expected. One study of note came from the J.P. Morgan Chase Institute (JPMCI), which examined consumer spending patterns.

Rather than dissecting surveys, which is the traditional way of gauging consumer sentiment, the JPMCI’s study looked at real-time purchases based on more than 25 million credit cards issued by the institute’s parent bank.

I give more weight to real spending patterns than to a survey about what consumers may be thinking at a point in time. To make a comparison, the difference is like reviewing the actual results of an election rather than the polls leading up to the vote.

According to the JPMCI’s study, consumer spending has been picking up, with most of the benefits flowing to the services sector. This trend indicates a pickup in discretionary spending. The view is that the pickup in consumption is being subsidized by lower gasoline prices. Add that trend to strength in the U.S. housing market, and loan growth should accelerate.

Money-centre banks, such as Wells Fargo & Co. (symbol: WFC) and Bank of America Merrill Lynch (symbol: BAC), would be natural beneficiaries of these trends, as these banks are the two largest mortgage lenders in the U.S. BAC also is the largest consumer bank in the U.S.

Indeed, we are seeing some of the benefits to these banks, based on their latest quarterly revenue and earnings numbers, which came in much better than anticipated. Although WFC’s numbers surpassed analysts’ expectations, some of the gains were the results of accretion from its recent purchase of General Electric Co.’s commercial-loan portfolio. The main concern for traders was weaker than expected loan profitability, which will improve when interest rates rise.

And while BAC’s loan margins also were in the crosshairs of traders, the shares benefited from lower than expected legal costs. BAC has been targeted by so many groups since the global financial crisis that any reduction in legal costs is a significant tailwind for the shares.

With these factors in mind, your clients may want to look at buying calls on either of these banks’ stocks. For example, the WFC January 2017 52.50 calls, at US$3.80 or better, may be attractive. Over the past 52 weeks, WFC traded as high as US$58.77. The January 2017 expiration gives you more than 15 months of time value to take advantage of a Fed interest rate hike and an improving economy.

With BAC, look at the January 2017 17 calls at US$1.15 or better. The shares have been as high as US$18.48 over the past 52 weeks and should breach that level in a rising interest rate environment.

The Canadian banks also make for interesting plays, although the metrics are very different than in the U.S. An interest rate hike in Canada is not a certainty and may hinge on where the oil price goes in the interim.

The sharp, rapid decline in the price of oil had an immediate impact on Canada’s economy. The benefits from low oil prices are just beginning to kick in, which partly explains Canada’s improving gross national product.

With fewer sparks to drive Canadian banks’ valuations, and the solid dividend yields available, your clients might want to consider writing shorter-term, “out of the money” covered calls.

Bank of Montreal generates a 4.45% dividend yield. Buying the shares and selling, say, the January 2016 78 calls at $1.25 provides some decent short-term returns if the stock’s price stays the same or rises slightly. The three-month return, if the stock is “called away,” is 6.26% (including dividends). The return if the stock price is unchanged is 2.75%, and the downside break-even (accounting for the dividend) is $73.28.

Bank of Nova Scotia yields 4.64% and, at the time of writing, its January 2016 62 calls were trading at $1.35. If you buy the shares and write the January 62 calls, your client’s three-month return, if exercised, is 6.18% (including dividends). The return, if unchanged, is 3.37% and downside break-even is $58.27 (after accounting for the dividend).

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