When it comes to analyzing a dividend yield, the old adage of "if it seems too good to be true, it probably is" is a good rule of thumb to follow. All sorts of stocks, ETFs and CEFs offer yields of 10% or more, but a lot of them prove unsustainable. High yields on stocks can be a result of a cratering share price and an impending dividend cut. CEFs often have fixed distribution yields that they can't generate the necessary gains or income to support. If not one of those reasons, the market environment may simply be ready to turn and push a sector or style out of favor.
That's why I had a healthy dose of skepticism when I took a look at the new Treasury Buy/Write ETFs from iShares.
In August of last year, iShares launched a trio of covered call ETFs based on bond indexes - the iShares Investment Grade Corporate Bond BuyWrite Strategy ETF (LQDW), the iShares High Yield Corporate Bond BuyWrite Strategy ETF (HYGW) and the iShares 20+ Year Treasury Bond BuyWrite Strategy ETF (TLTW).
There are plenty of funds out there using covered call strategies on top of equity portfolios, but these are the first to do so using fixed income. My immediate thought was "why didn't somebody think of this before". Especially over the past year, corporate bonds and long-term Treasuries have been just as, if not more, volatile than the S&P 500. If they can work as a high yield strategy for stocks, it stands to reason that they can work just as well using fixed income as the underlying. iShares apparently agrees.
iShares 20+ Year Treasury Bond BuyWrite Strategy ETF (TLTW)
Of the trio, the one I'm most interested in is TLTW. In my "13 Predictions For 2023" article earlier this year, I called out Treasuries as one of the best potential trades of the year. Recession risks are likely to keep growing and credit risk largely has yet to be priced into corporate bonds. That puts corporate bonds in a unique position to do fairly poorly as they year progresses. Treasuries, in that scenario, are likely to pick up a lot of safe haven trade interest from investors and could easily post double digit returns.
That, in my opinion, makes Treasuries a great opportunity outright, but I did a double-take when I saw that TLTW was paying out dividends at a 20% annualized rate! The fund is still less than a half year old and you don't want to draw too many conclusions based on small sample sizes. Still, I was struck by the consistency of the distributions TLTW has made thus far.
The average of those monthly payments has been $0.5649 per share. Annualize that over 12 months and you get an annual dividend of $6.7788 per share. TLTW has a current share price of $34.15 as I write this. Do the math and you've got an annualized yield of 19.9%. That's a hell of a yield, especially coming from a strategy that will generally be more conservative than the underlying index in isolation.
But, that's still a 20% yield. Investments just don't typically pay anywhere near a 20% yield (at least on a sustainable basis). Is TLTW the exception to the rule or is it setting up to come back down to earth?
TLTW Profile
TLTW's strategy is pretty simple. It invests in the iShares 20+ Year Treasury Bond ETF (TLT) while writing a series of one-month call options on the underlying. Those calls are generally 2% out-of-the-money at the time they're written. The 2% OTM strikes a nice balance between income maximization and share price growth potential. There's a high enough option premium to make the strategy worthwhile, while offering a better chance that the option expires worthless, the ideal outcome for a covered call strategy.
To understand if the 20% yield is sustainable, we need to look at the factors that work in TLTW's favor as well as those that work against it.
Factors Supporting The 20% Yield
Treasury Volatility is High
This is perhaps the biggest factor working in its favor. If you look at the Move Index, which is essentially the VIX of the bond market, it's near its highest level since the financial crisis. High volatility equals high option premiums. We're seeing them in equity covered call ETFs, where yields are routinely around 12% for full overlay strategies, and we're definitely seeing them early on in these fixed income covered call ETFs. As long as the bond market is trying to figure what the Fed is going to do, tries to price in a U.S. recession and worries about a potential sovereign debt crisis or U.S. credit rating downgrade, volatility in Treasuries is likely here to stay.
The Fed's Desire To Keep Rates High Indefinitely
If the Fed is to be believed (a BIG if), the Fed Funds rate will hang around the 5% level for most of 2023. That will definitely keeps yields on the short end of the curve high if the Fed follows through, but the long end tends to be more influenced by economic conditions. This scenario would probably keep the yield curve inverted, but it probably also keep the entire yield curve higher than it should be.
If TLT can keep its yield closer to 4% and overall market volatility remains elevated, there's a case to be made that TLTW's yield can keep hovering around the 20% mark.
Factors Working Against The 20% Yield
Yields Like This Are Rarely Sustainable
If you look at history, covered call strategies have typically yielded around 4 times what the underlying index does. The Global X S&P 500 Covered Call ETF (XYLD), for example, has traditionally yielded around 8% while the S&P 500 yields 2%. TLT still has a yield of around 3.5%, which, using that rule of thumb, would put a covered call yield at around 14%. And that's using the same scale applies, which may not be the case.
TLTW looks like it's punching over its weight right now and that could be poised to correct over time.
When Recession Nears, Yields Are Likely To Fall
Almost everyone agrees that a recession sometime in the next 12 months is more than likely. Treasury yields often fall significantly during recessions because investors pile on the flight to safety trade. If you look at the 10-year Treasury yield around recessions, it's average a decline of around 300 basis points from peak to valley.
Treasuries would be beginning from a much lower starting point this time around, so perhaps a 300 basis point drop would be a little much, but I wouldn't be surprised to see the 10-year fall back into the 1-2% range again. If that happens, you're probably looking at TLTW's yield to fall significantly as well. To what level is anyone's guess but it's probably nowhere near 20%.
Conclusion
Based on current conditions in the bond market, I think TLTW's 20% yield can be sustainable for at least a little while. It will probably require yields on the long end of the curve to at least remain around where they are now and bond market volatility to stay high.
Over the long-term, those conditions are probably unsustainable. I believe yields are likely to be falling throughout 2023 and that hurts the chances that TLTW can hang on to this extraordinary yield. I think double-digit yields could still be reasonable to expect, even if it's not 20%.
When it comes to TLTW, grab that 20% yield while you can because it probably won't last forever!
