(With this article, Signal from Noise inaugurates an Other Voices format, to be published occasionally as we run across portfolio managers with investment themes and stock ideas relevant to subscribers. It’s our intention to familiarize you with the views of successful money managers, some you might have read about, but, more importantly perhaps, some you might not. Today’s piece was written by Craig Van Hulzen, John Pearce and Stefan ten Brink, portfolio managers at Van Hulzen Asset Management, El Dorado Hills, CA. It deals with the covered calls strategy. All investors should find it interesting, but particularly those interested in income and yield combined with relatively low risk.)

We have never understood the value proposition of high yield bonds. As fundamental, bottom-up value equity managers, you might call us a little biased, but we believe the category is called “junk” for a reason. 

Despite residing in the fixed income asset class, which has a traditional reputation for safety and stability, high yield bonds carry significant credit risk instead and offer little downside protection during equity market declines. The volatility of this bond subset is two to three times its investment grade counterpart. The drawdown in junk bonds was -32% during the 2008 financial crisis. Elevated credit risk leads to widespread defaults whenever markets hit turmoil.

The returns from stocks and high yield bonds are closely correlated, so the latter offers practically no diversification from equities. We suspect the average investor in, for example, this category’s leading ETF, the SPDR Bloomberg Barclays High Yield Bond ETF (JNK) does so for the yield but also doesn’t truly understand this asset (or the level of risk taken on). Junk bond corporations entice many income-seeking investors, often retirees living on their own fixed incomes in order to meet their living expenses.

There is a blue-chip, high quality strategy—covered calls—that can offer the same or better yields than HY bonds. The investor’s time horizon matters:  Using covered calls is not for traders but for long term investors.

Owning a portfolio of individual debt issues of poor credits is the same as building a housing development on foundations of sand. The first weather event could wash away the foundation and damage the entire development. A junk bond ETF selling point is that all the credits in it won’t go belly up at once. We think even if you own a lot of junk, it’s still junk.

For example, say an acquaintance you meet at a party asks you for a loan at 6% interest. Granted, the business hasn’t made a profit in almost 5 years, but he tells a pretty good story about the future prospects. You take a look at his financials and find the following: The company has $200 of cash on hand and $13,000 of debt. You, being a math wizard, do a quick calculation and figure out that this business has a default probability of approximately 43%. This concerns you, because a 43% chance of losing your entire investment and a 57% chance of earning 6% has a negative probability outcome.

Covered calls are for investors who want both income and price appreciation. It might not return as much in total as straight equity over the very long term, but the risk is significantly lower and the annual dividend income higher. Now, say you bump into another friend at that party and she is investing in a well-known company that pays a 3% dividend yield and has almost zero default risk. This friend is using covered calls that could boost that yield to 9-10%. Seeing as you were contemplating a 6% upside without any price appreciation potential, you are intrigued by the 9% yield and some upside that can be earned in the covered call investment.

We believe most informed investors would choose the safer bet with the higher yield. Although the above examples are stylized, the numbers are based on real world cases: a top 10 holding in the high yield index iBOXX,  Community Health Systems (ticker CYH) and one of our top 10 holdings, Johnson & Johnson (JNJ). We have presented a fundamental comparison of the two companies in the chart nearby.

As you can see, there is a stark difference between the two opportunities. CYH has an ROI well below its cost of capital, carries nearly 100% leverage, is barely covering current interest payments, and in fact has a 43% default probability according to the Merton model, which uses debt totals and maturity dates to assess a company’s risk of credit default. JNJ, on the other hand, earns an ROI of four to five times its cost of capital, carries very little leverage and has 0% Merton model default risk.

We don’t pick on CYH in particular, and we wish them luck refinancing their debt and surviving this difficult time. But we do believe it’s a good example of the type of risks buried in high yield bond funds. And while the Federal Reserve has instilled some confidence in this category by announcing that they may buy some of these ETFs, this does not change the fact that many of these companies may not be able to meet their obligations. Junk is still junk.  To us, the Fed’s commitment is like putting lipstick on a pig, to use a Wall Street cliché.  But it fits.

None of this even addresses the fact that bonds in general have enjoyed a nearly 40-year bull market as rates have dropped from mid-teens to zero and will likely face significant headwinds once rates begin rising again.

We believe covered calls offer a better alternative to junk bonds. Our strategy, which has an 18+ year track record, has a slightly lower standard deviation than the IBOXX high yield bond index (9.3% versus 9.4% over the same time period). And our strategy has outperformed the IBOXX by 2.2% per year. We have done this by investing in high quality companies with fortress balance sheets and using call options to increase yield and reduce risk, just as our example highlighted.

On a cumulative basis, investing $100 into our strategy would have resulted in $380 compared to $262 for high yield bonds over the same period. (See chart nearby.)

There is of course another key distinction between the two approaches: while junk bonds typically struggle during periods of higher downside volatility, covered calls can actually thrive in that environment.