By Paul Price of Market Shadows
Zero Interest Rate Policy (ZIRP) has been a curse for risk-averse savers and investors. Bank CDs, T-bills, money market accounts and corporate bonds have almost never paid less than they do today.
That led many investors to chase after yield in alternative investments, at prices that they shouldn’t have paid. Holders of the natural gas transmission company Boardwalk Pipeline Partners (BWP), a master limited partnership (MLP) were recent casualties in this struggle for income.
Units (similar to shares) of BWP had spent most of the last seven years trading between $24 – $30. Its valuation was largely based on its cash distributions, which averaged 7.1% over the entire period 2006 – 2013. Investors didn’t pay much attention to anything but BWP’s yield.
Last month, management cut the quarterly payout from 53.25-cents to 10-cents. BWP cratered, plunging from above $25 to around $12. BWP closed last week at $12.55 after hitting a new all-time low of $11.99 early Friday.
 
Disgusted holders who suffered big losses have been dumping BWP while other investors, who like the 3.2% current yield, see rebound potential. These new investors have been buying in for the rebound potential, the current (lower yield), or both.
Option savvy income seekers can use the drop in BWP to try for better returns than before the dividend was slashed.
Better returns are likely achievable using a buy-write strategy–i.e., buying shares of BWP while writing (selling) covered calls. One idea is to sell calls that expire at the close of trading on September 19, 2014, about six months from today.
 
Selling calls on BWP limits upside potential but brings in substantial upfront payment in the form of option premium. The income often rivals anything available in today’s ZIRP environment while also reducing the risk of holding the underlying shares.
Here is an example based on prices that were available just before the close on Friday.
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That best-case scenario will play out if Boardwalk goes up, remains unchanged or even if BWP drops down to $12.50 (but no lower). An almost 33% rate of return sounds pretty good in a zero interest rate world.
There’s no guarantee that BWP can’t decline but the money from the covered calls would mitigate up to a 13% drop if the shares fall.
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The buy-write’s break-even price is lower than any actual open market transaction in BWP. It is cheaper than BWP’s low in the crash of 2008 and during the flash crash of 2010. Both those occasions proved to be spectacular buying opportunities–not good times to sell.
 
The odds on this trade working out well are quite good. The biggest ‘risk’ is that larger profits are missed (“missed profits”)–the possibility that BWP is much higher than the current price by September 19. Making 15% won’t sound so good if BWP is up over 30%. In our example, any move to higher than $14.48 before expiration date would not be captured.
Regardless of the missed profits potential, covered call-writers should never have to apologize for capping results at very attractive rates. The technique reduces risk and lowers overall portfolio volatility.
If missing out on big moves would make you crazy, consider selling higher priced strikes, such as $15 or $17.50, to allow for greater upside. The cost of trying for a higher move in the stock is losing some of the risk protection.
Disclosure: Long BWP, short BWP naked puts, short BWP covered calls
