The uses of an underground toll road

According to the company, there are risks that include “the expected demand for energy crude oil, natural gas, natural gas liquids and renewable energy, and the prices of these commodities.”

Other factors include exchange, inflation and interest rates, all of which can impact economies and the business environments of Canadian energy producers, which use ENF’s transportation and storage facilities.

Financing future growth also can have a meaningful impact on ENF’s share price. This point was painfully evident when management recently announced it has entered into an agreement with a syndicate of underwriters led by Bank of Nova Scotia, BMO Capital Markets Corp. and CIBC Capital Markets Inc. for the purchase and distribution to the public of 17,699,000 additional ENF common shares at a price of $28.25 each. That announcement knocked more than $1.50 per share off ENF’s price in one day.

Still, the issuance of new common shares is key to managing future growth. Simply earning revenue on the current infrastructure is not enough.

Managing cash flow within an income-oriented portfolio is a very different way of thinking about investments. Unlike clients who are in the accumulation phase, during which growth is key, income investing is all about maintaining principal, so that the distributions from the assets are retained for the longest possible time period. As such, investments that have an “income first” mandate are key to income-oriented portfolios.

Variability also is a key element within income mandates. Portfolio managers refer to this as “sequence risk,” which is how a portfolio’s income is affected by fluctuations in the financial markets. Income-seeking clients want a regular stream of income – and that income is required regardless of the value of the portfolio. If the required income is greater than the dividends and distributions created by the portfolio, it must be delivered by selling portfolio assets. If you are forced to sell assets when prices are declining, there is no chance of recovering that principal during periods when the market is rising.

The key is to recognize sequence risk and to manage it appropriately. You cannot eliminate market volatility; but the more capital you generate through distributions, interest and dividends, the more you can reduce the risk associated with sequence risk. This ability effectively extends the timeline before clients reach what is affectionately referred to as the Age of Ruin (i.e., the point at which your client runs out of money).

ENF is an interesting security for an income mandate because this stock delivers an above-average yield that will grow if ENF can manage the attendant risks. We also know that the stock can be quite volatile for a number of reasons related to the aforementioned risk factors and management’s stated goal of increasing distributions over the next three years.

As a stand-alone investment, the inherent volatility is a problem – unless you are willing to use options as part of your ENF strategy. Options as an add-on feature can enhance the position. That’s because higher volatility results in higher option premiums.

With that reality in mind, selling covered calls can enhance the yield if your client is willing to sell their shares at a price slightly higher than the current market value.

For the purposes of this discussion, we will assume that ENF is trading at $28.50 a share (the price at the time of writing) and the ENF October 30 calls are trading at 60¢ per share.

Note that ENF pays monthly distributions of 0.155¢ per share. The total distributions between now and the option’s October expiration date (Oct. 21, 2016) for the call options will equal 77.5¢ per share.

The objective is to sell the ENF October 30 call options at 60¢ per share. If the ENF option is exercised and the underlying shares must be sold to the call buyer in October, the six-month return is 10.1%.

In a twisted way of thinking, the return, if exercised, is a two-edged sword. It is the best possible outcome, but also the clearest risk.

While your client earns the maximum return, the underlying shares are sold and the income stream is removed from the portfolio. At that point, you would have to assess the situation.

If ENF remains unchanged during this six-month window, your client retains the shares and the 60¢ option premium while continuing to earn monthly distributions. The six-month return if the share position remains unchanged is 4.8%.

The covered calls and monthly income provide a buffer against sequence risk. The capital gains treatment for covered calls is tax-advantageous. Even at the risk of losing the shares at a higher price, the benefits outweigh the negatives.

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