Special Dividends, 2008 Forecast, Adding Portfolio Income

'Tis the season for special dividends. These one-off wonders are often used to distribute capital gains or otherwise to reward shareholders at the end of the year.

We choose to exclude these from our QDV and yield calculations, because they should not be counted on as regular dividends and to include them would distort what is happening to growth of the regular dividend. One should pay close attention to the classification of special dividends as well, meaning their tax treatment. They may or may not qualify for the lower tax rate, particularly if it is a return of capital.

Last January, I made a prediction for end of year yield on the dividendsrus portfolio, which was 3.8%. Well, we came up a bit short at 3.53%, at least as of today. No excuses, but an explanation is in order. Partly this shortfall resulted from too much portfolio turnover in 2007. Also, when we make new investments to the portfolio, these are obviously placed at an 'initial' (and usually lower) rate -- ditto when adding to existing positions. At any rate, this year we will have to restrain our optimism by discounting for these two factors. The good news is that nominal cash flow will still be increasing at an accelerated rate due to the underlying dividend growth. For example, we looked at our annualized trailing dividend cash flow ending November 2007 and compared it with November 2006. It is 27.5% higher despite the fact that portfolio yield increased “only” to 3.53% today.

If end of year yield on cost is 3.53%, and portfolio QDV is around 21%, then the indicated yield at the end of 2008 should be about 4.27%. But this assumes we do no transactions and do no reinvestment of dividend income. So, we will have to make some kind of adjustment that assumes some turnover rate, and assumes a 'reset' yield average for new investment. Further, we will have to adjust for added investments. So, we will scale back our forecast for indicated yield to 4% for the end of 2008. We’ll see if we can do better next year. Of course, 2007 was not really a bad year at all, despite the housing turmoil.

Finally, one strategy you may wish to consider for conservatively adding income to your portfolio is to write out of the money calls against it.

It would work like this -- say you have a diversified portfolio worth about $150K. You would write SPY (S&P 500 index ETF) calls against the total value of that portfolio. If SPY is trading at $148 a share, then 1000 shares of SPY ($148K) is approximately equivalent to that portfolio value. The strategy is to write ‘far-out-of-the-money’ calls each month for additional modest income. Today, SPY closed at about $148. Jan calls expire in about 28 days. If you review SPY's trading history, you will see that it rarely moves more than 5.5% within a 28 day period. So, if you write (short) calls at $156 (which is around 5.5% higher than SPY is today), they will most likely expire worthless by January's expiration. That means you get to keep the option premium. Since the current bid for Jan 156 calls is around $0.28, and the hypothetical portfolio is equivalent to 1000 shares of SPY, you could write 10 contracts with a total value of $280. That amount would be credited to your account, and become your income if those contracts expire worthless.

One big issue with this strategy is that you do not actually own SPY, and so most brokers will not allow you to write 'naked' calls on it, even though your portfolio is a close facsimile.

Assuming you can get some latitude your broker might allow you to write call spreads first. This approach is not nearly as attractive. In this case, you would be forced to take another action. You would have to buy an equivalent number of calls against the calls you wrote, at a higher strike price. This will reduce your income. In this example, you might buy a spread $5 higher than the Jan 156 calls you sold. So you would buy 10 contracts of SPY with a strike of $161 (156 + 5). Fortunately, they cost you only $0.04, but it still reduces your income by $40, and now you have to make two trades, with two commissions. So instead of $280 in income, you have $280 - $40, and then about -$45 more in commissions, so your income has been reduced to around $195 (then as the final insult, that amount gets taxed). The reason your broker prefers this is that your potential loss is limited to the $5 difference in the spread, whereas using the first strategy without the spread opens you to 'potentially unlimited losses'. Actually, that is not the case as we will soon see.

About the risk of writing naked calls -- If for some reason the stock market rockets 10% in one month, you are basically giving up 4.5% of your portfolio's move via the loss on the short calls, but you will have also made 5.5% on the underlying portfolio (10% - 4.5% loss on the options) assuming your portfolio has a high correlation to the index. It had better if you are considering this strategy. In the event you get 'assigned' while naked, which means you do not own the underlying stock, your broker will short 1000 shares of SPY, using your margin account, so he can deliver the called shares. You will then be short 1000 shares of SPY, and have a neutral market position (long the value of your portfolio, and short a roughly equivalent amount of SPY). By the way, if the market has moved up that far and that fast, maybe it would be a good thing to be hedged.

If you decide instead to just write calls on each of your individual stocks, you will have even more transaction costs to eat up your profits, plus the volatility of individual stocks is so much higher. Chances are higher that some of those stock positions will be called away.

I think the only profitable way to make money at this is to do the spreads for a period of time, then request and obtain broker approval for a higher risk level to write naked calls. Then, it will be a single transaction with only one commission. The point here is that using options this way can generate some modest additional monthly income, and can be used to effectively increase the portfolio yield. If you have a $150K portfolio earning 3.5% in annual dividend income ($5,250), then you could be adding around $2400 which would increase your portfolio yield to about 5.1%.

Is the risk, not to mention the accounting and tax hassles, worth doing it for? Maybe yes, maybe no, but it certainly is a viable approach for conservative investors who can tolerate the risk.