Finding fixed-income substitutes

Although a growth investor would not necessarily gravitate to BCE, clients who recognize the value of diversification within a portfolio could do worse than this blue-chip stalwart in the Canadian market. The company is rich in cash flow and has a management team intent on giving back to shareholders. BCE has increased its quarterly dividend 13 times since the global financial crisis of 2008-09. The most recent bump was announced in January, which will see the quarterly dividend rise to 71.75¢ per share, payable in April.

Given the trajectory of the dividends, you might consider using BCE as an alternative to bonds within a client’s portfolio. That strategy is not as far-fetched as you might think.

You may recall that prior to the financial crisis, BCE was in play. The Ontario Teachers’ Pension Plan Board (OTPPB), BCE’s majority shareholder at the time, wanted to use the cash flow from BCE’s continuing operations to fund a portion of the OTPPB’s pension liabilities – which sounds a lot like a fixed-income alternative. The initial deal fell apart when two hedge funds that were partnering with the OTPPB were caught with a flood of redemptions at the height of the financial crisis. In the end, the hedge fund partners could not come up with their share of the capital necessary to take BCE private.

Teeter-totter effect

But that was then and this is now. Since the fallout from the financial crisis, BCE management has done exactly what the OTPPB thought was reasonable. As mentioned, BCE management has increased the dividend payout on a regular basis.

In the current environment, you could argue that what is bad for bonds is probably not good for BCE. All true – to a point. However, with interest rates expected to rise, we know with certainty that fixed-income securities will drop in price. Such is the “teeter-totter effect,” in which bond and preferred share prices move inversely to the bonds/preferred shares fixed-interest rate.

For BCE, the linkage between rising rates and a lower stock price is not as clear-cut.

To begin with, the yield on BCE (4.92%, given the most recent dividend increase) is well above the rate payable on 10-year corporate bonds. So, there is some room to manoeuvre in a market in which BCE’s income is expected to increase. The variability in BCE’s cash flow gets reflected in management’s push to bump up the dividend continually, a process that is vastly different from the fixed interest payable on a bond.

Second, what is driving the higher interest rate scenario is a normalization of the economy, which means more growth and, perhaps, higher inflation. Any increase in economic growth is positive for BCE’s earnings trajectory. And, although an increase in inflation is not a positive, it certainly isn’t a major negative for BCE.

What we have, then, is a company that your clients could use as a fixed-income proxy within a portfolio. Given historical trends, in which BCE management tends to increase dividends each year, I would not anticipate another increase this year. So, you might think about augmenting the cash flow from the quarterly dividend by selling covered calls on BCE.

Increasing returns

The sale of covered calls increases the total return from the overall position. By selling, say, the BCE January 59 calls at $1.90 per share, the covered call adds almost the equivalent of three more dividends. This is additional income that provides a tax advantage to your clients (under current tax rules). Option premiums are taxed as capital gains. Think of the premium received from the call option as an enhancement to the overall strategy. Again, that is something not possible with a fixed-income instrument. And the sale of the call option provides some downside protection.

The yield to maturity – in keeping with our fixed-income alternative analogy – over the next 11 months is 8.11%, assuming the stock price remains where it is trading currently. That’s calculated by the premium received ($1.90 per share), assumes the current stock price ($58.75) and four dividend payments totalling $2.87.

If the stock is called away at $59 next January, the return gets bumped to 8.54%. Again, this return is calculated assuming the current stock price ($58.75), the sale price if assigned ($59), the premium received ($1.90), plus four dividends based on current payouts equalling $2.87.

As for the downside, the premium received reduces the downside risk to $56.85. Should you prefer to take a shorter-term view, your client could sell the BCE August 59 calls at $1.25. The return is less on this approach, but if the shares are not called away in August, you will have the opportunity to sell another at-the-money call after the August expiration.

With the shorter-term strategy, the seven-month return, if unchanged, is 4.48%, while the return if called away at $59 per share is 4.91%. This accounts for the $1.20 in premium received plus two dividend payments totalling $1.435 per share. Looking at downside protection, the premium received reduces the cost base for the shares to $57.55.

Either approach makes sense for clients seeking income. The choice of which timeline best suits a client comes down to your view on the outlook for BCE shares.

In either case, not bad for a bond substitute.

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