XYLD ETF: Unsuitable for Retired Investors Due to Dividend Drop (NYSEARCA:XYLD) – Seeking Alpha | Jewelry Dukan

Dilok Klaisataporn

Many investors today are looking for high-yield investments that provide consistent dividend income. This trend has led many investors to buy assets or investment products with high returns and equally high financial risk. As the US and global economies face increasing deterioration, many investors are at risk These formerly “safe” products may work by sacrificing high returns for high tail risk exposure.

One investment product that has become very popular with many income investors is covered call ETFs, such as the S&P 500 covered call fund (NYSEARCA:XYLD). On the surface, XYLD and its peers appear to be a great income strategy given the 13% TTM yield. However, in the event of a prolonged bear market, covered call ETFs are likely to lose capital, possibly until most of their value is lost. Additionally, they absolutely shouldn’t be viewed as stable income levels, as is the case with most dividend stocks and bonds. Your income level is unstable because option premium returns are tied to capital. So if capital falls in value, the returns on option premiums will also fall. This significant risk factor, I believe, should be understood by investors who are retired or rely on a steady stream of income.

I warned about XYLD’s risk in January in “XYLD: A 9% Yield Is Far From A ‘Free Lunch’ When It Comes To Covered Calls,” as did a small handful of analysts who cover the fund’s risks. XYLD has since fallen 20%, resulting in an overall loss of 13.2% after dividends. In my view, XYLD’s down pattern has just begun and could see significantly larger losses in the coming months given XYLD’s mechanics and economic trend. With that in mind, I think it’s a good time to take a closer look at the ETF to clarify its risk factors.

Not all dividends are created equal

In general, covered call strategy funds are a newer concept and were not popular during the last major bear markets like 2000 and 2008. With this in mind, many investors may not understand the risk of covered call strategies. Over the long term, covered call strategies are expected to deliver similar total returns as the underlying index – in the case of XYLD, the S&P 500. However, it is virtually guaranteed that a covered call strategy will result in capital erosion over the long term.

XYLD’s capital has been roughly flat since its inception, but there have been no long-term bear markets. A quick pullback like 2020’s is unlikely to cause a large capital drop as XYLD loses during bear market rallies. This mechanic can be seen in XYLD over the past year:

diagram
Data from YCharts

XYLD falls just as much when the market falls as it has no downside protection against the market. After accounting for dividends, XYLD has very modest downside protection as premiums spike temporarily on market declines. However, this buffer typically only reduces 1-2% declines during a crash (so a rapid 10% drop in the S&P 500 can result in an overall 8-9% drop in the XYLD after dividends).

More importantly, XYLD’s equity can fall quickly during sustained bear markets. As seen in the chart above, XYLD falls with the S&P 500 but does not rise much during bear market rallies. Over time, this factor causes XYLD’s capital to shrink. When investors reinvest dividends into XYLD, total returns should still be close to the S&P 500. However, investors who withdraw XYLD’s dividend should expect their capital to eventually drop towards zero. Many may not be aware of this risk as XYLD’s capital has been supported by a rising market. However, if we create a ratio chart of XYLD’s price to the S&P 500, we can see its falling value:

diagram
Data from YCharts

Note that XYLD’s expiry pace increases during bear markets like 2020. Given the nature of covered calls (limiting bear market rallies), the rate of expiry is likely to be more aggressive during prolonged bear markets. Given the ongoing bear market, I believe we could see more significant permanent declines in XYLD’s capital.

XYLD’s dividend has remained constant as the fund has not experienced a capital decline. However, if an extended bear market ensues and XYLD’s price falls consistently, the dividend will eventually fall by the same amount. For example, if XYLD’s price fell from $40 to $20, its annual dividend would likely fall from $5 to $2.5. This is because monthly option premiums are typically 1-2% of invested capital (depending on volatility and strike price). So if the invested capital decreases, the premium received will also decrease. This factor distinguishes XYLD from a bond, a preferred stock, or a high-quality dividend stock usually sees dividends flat as asset prices fall.

These factors are not necessarily critical for investors looking to reinvest dividends in XYLD. However, many investors in XYLD may retire or need a steady stream of income. XYLD can have a significant income stream during bull markets, but its dividend (and price) is likely to decline permanent during extended bear markets, as opposed to traditional stock ownership. In my view, it is critical that XYLD investors fully understand these risk factors and not simply buy the fund based on its historical performance — largely because it has not been tested during an extended bear market.

Stocks are likely in an extended bear market

There are no certainties in the markets, but a wealth of data and trends point to a lower stock market. Stocks fell in the first half of 2022 and rose in recent months as the inflation outlook softened with lower crude oil prices. However, equities faced another wave of declines following August’s CPI data, which suggested inflation may be more stubborn than previously expected. In addition, many long-term economic indicators are showing very negative signals, including consumer sentiment, the yield curve and the manufacturing PMI:

diagram
Data from YCharts

Consumer sentiment informs us of consumer strength, manufacturing PMI informs us of corporate strength and the yield curve signals bank strength. It is historically rare for all of these measures to be in an unfavorable position. In the case of 2008, consumer sentiment was weak while Federal Reserve stimulus caused the curve to steepen rapidly, benefiting banks and businesses. Banks and other businesses had a tougher time during the 2000 recession, but consumer sentiment was strong as Internet innovation increased. Consumer sentiment was also strong between 2017 and 2020 (pre-lockdown), while banks and businesses slowed. Still, as in 2008, the Fed’s stimulus measures during the lockdown ensured a quick recovery, but there was no lasting recovery in consumer sentiment.

The positive impact of the Fed’s immense stimulus appears to be over as the yield curve quickly returned to inversion after steepening in 2020 and the manufacturing PMI has declined. As the pace of quantitative tightening accelerates in September and beyond, I expect the deterioration for banks and corporates to continue to intensify. Consumer sentiment has edged up from extreme lows but is unlikely to recover any further given ongoing consumer price inflation.

Overall, this situation is very similar to the late 1970s and early 1980s – the last period when all three indicators were negative. Not surprisingly, this was also the last period in which inflation was near (or above) double digits, driven mainly by supply-side factors. During this time, the Federal Reserve’s efforts to cut consumer demand (to end shortages) had to become very aggressive. Importantly, there is very little the Fed, or government in general, can do to repair falls in overseas production, which means it must act to reduce consumption in order to moderate prices.

In my view, this economic situation does not bode well for the stock market as rising costs make it difficult for companies to maintain profit margins. Initially, companies were able to pass the cost on to customers, but the collapse in real wages and savings implies people are unlikely to pay higher prices – meaning many companies are likely to see margins or revenue declines. Stock prices are ultimately tied to earnings prospects. I don’t think most investors or analysts have priced in the potential long-term earnings decline that can occur if the wage-price spiral widens or interest rates stay high for longer.

The final result

I believe that XYLD is a bad investment in general that may be unsuitable for many income investors. XYLD’s dividend and capital are likely to face permanent declines if the stock market bear market lasts much longer, as covered calls “limit” gains from bear market rallies. This factor may not be essential for XYLD investors looking to reinvest dividends, but those who withdraw dividends may soon find that the stream of income drops off dramatically.

The stock market could be in for a sustained recovery that will protect XYLD’s capital and dividend. However, when I look at the economic and financial trends related to consumption, business activity and banking, I believe it is clear that the economy is in a stagflationary environment. This environment usually means that employment levels can remain high even if the economy slows and profit margins collapse (see wage-price spiral). If global events cause scarcity to increase further, this trend may become even more aggressive. In my view, this economic situation is necessary for the long-term health of the US economy (since inflation indirectly reduces debt and boosts domestic manufacturing) but is likely to result in a long-term decline in financial asset valuations. Additionally, I believe the mechanics of covered call investing give XYLD greater negative exposure to this potential.

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