Q2 2022 Covered Call Comments
by Robert Cagliola, CFA and Robert Hahn, CFA, on July 25, 2022
The second quarter was marked by exceptional weakness as the S&P 500® declined by 16.4% with very few places to hide. For the first half of the year, the index is down 20.6% reaching bear market status for the second time in just a little over two years. Market weakness was driven by Fed tightening and raising the Fed Funds rate to cool inflation which has been at multi-decade highs. Inflation as measured by the Consumer Price Index (CPI) rose 8.6% from May 2021 to May 2022, the largest increase since December 1981. The Fed responded by increasing the Fed Funds rate by 0.75% to 1.50% -1.75%, the largest rate hike since 1994. In addition, beginning in June, the Fed started to let $47.5B of securities roll off the balance sheet per month, ramping up to $95B per month In September. Investors are concerned that the Fed’s tightening and rate hikes, though necessary to combat inflation, could lead to a recession. The Atlanta Fed’s GDPNow model is predicting a 2.1% decline in GDP during Q2, suggesting that we may already be in a recession. As a result of the concerns about inflation and the Fed’s ability to control it while avoiding a recession, there were very few places to hide as both stock and bonds declined for two consecutive quarters for the first time in four decades with only one sector in the S&P 500 (Energy) in positive territory thru the first half. One point of optimism may be that the yield on 10-yr treasuries closed the quarter at 3.02% after reaching 3.5% in June. Commodities also declined from recent highs, with oil closing at $105.97 off its 2022 highs of $130.50 and copper closing down 1.3% in Q2. While commodity declines and the recent decline in 10-yr treasury rates suggest that inflation possibly peaked last month, the declines could also suggest that future demand may be negatively impacted by a recession. Stock performance in the second half will likely depend on a possible moderation in inflation and in the Fed’s pace of rate hikes and quantitative tightening.
Portfolio Equity Positioning:
During the quarter, we increased our oil exposure with the purchase of Schlumberger, while reducing our Consumer Discretionary sector exposure. Several names got called away in Q2 in the Energy, Healthcare and Consumer Staple sectors. We opportunistically repurchased shares following pullbacks. We remain overweight in Consumer Staples and Healthcare relative to the S&P 500® Index as we stay more defensive.
Call Option Premium:
The current quarter was very similar to the last in terms of heightened volatility and premium capture, averaging 1.8% simple return that annualized to an 8.0% run rate based on average days to maturity. For several quarters now, we have generally moved from 20 to 30 delta at initiation on the average short option position. Therefore, we are seeking to capture more premium by writing at the higher delta. For every position, the decision is made to maximize return by grabbing income through the option writes or allowing for more upside participation with less option premium. Given the lack of visibility into earnings in the near term, we have continued to shift to a more defensive stance with our call writing and overall portfolio construction. In addition to capturing significant premium, average writes were initiated 10% out-of-the-money allowing for compelling upside participation which compares favorably to past quarters. Overall, the portfolio written coverage averaged 57% while working toward a 60% target.
In the second half, we expect the market will continue to experience elevated volatility in both directions until investors gain more clarity on inflation and the aggressiveness of Fed policy. There is potential for a market rebound later this year if inflation moderates and the Fed becomes more measured in its future rate increases and quantitative tightening. We expect companies to be more conservative in their guidance during the upcoming earnings calls and earnings estimates will likely decline as a result. Equities, particularly dividend payers, should continue to be a good hedge against inflation and call writing should also continue to thrive in this environment, given heightened volatility and, therefore option premiums.
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