Leveraged Covered Calls

In the money covered calls (ITM CC) offer a combination of returns with downside protection - not dissimilar to single name FCNs. There is however a trade-off - greater protection comes with lower coupons. What if we could target higher coupons and yet have deep protection? Issuers often structure this through leveraged FCNs - the challenge with such structures is secondary liquidity, as well as substantial issuer fees. Enter, Leveraged Covered Calls.

Structure (with example)

• Long Stock - Micron (MU) @1074.89

• Short Deep in the Money Calls (400 Strike/ 17 Sep 2027)

• Moderate leverage (c35% of current stock price)

• Equity Needed = Share Price less Call Premium less Leverage

• Leverage Cost - assumed at 5%

Highlights:

• Unleveraged returns for the same strike are 8% (vs. 20.7% for the leveraged version)

• Similar returns in an leveraged structure have a 30% downside protection vs. 55% in the leveraged structure

• Losses amplify below breakeven

• Ability to early close (if vols compress/ underlying rallies or both) - unlike an FCN.

Suitability & Risks

• Investors comfortable with MTM volatility

• Investors willing to assume larger leverage for returns but entail higher losses on drop below breakeven

• Investors willing to forego upside in case of a sharp rally

• Allows small ticket participation (upfront equity needed is 1/5th)

• RISKS - A sharp drop (c65% of spot) can wipeout the equity

• RISKS - Rate Sensitivity - Every 100bp in higher interest costs knocks off c400bp of returns.

Pay-off Structure - B&H vs. Leveraged vs. Unleveraged ITM Covered Call