Bonds Used to Be the Income Answer for Retirees. Then Came the Covered-Call ETF That Pays Over 7%.

In 2020, the global economy descended into recession during the Covid-19 pandemic. Central banks around the world enacted an across the board interest rate cut in an effort to stimulate activity to revive the economy.  Markets responded. Bond prices rose, reducing yield significantly. 30-year mortgage rates, which started at 3.75%, fell to 3.0% by that summer. Although businesses managed to regain ground, the low interest rates severely impacted retirees, especially those who rely on fixed-income investments for their retirement nest eggs. 

Wall Street developed a slew of synthetic financial products to address the soaring demand for income. The notion of using a covered call option strategy to create premium income had long been utilised by options traders and was initially introduced by Invesco in 2007. However, this strategy was adopted with some additional tweaks by several firms, such as YieldMax, who created an entire catalog of ETFs with variations on this income model for both single stocks as well as portfolios of different stocks, with volatility a crucial component. Its double-digit yields and monthly (sometimes weekly) payouts caught the attention of many retirees and other investors seeking high-yield income.  

Banking titan JP Morgan entered the fray in 2020 with its own take on a covered call ETF: JP Morgan Equity Premium Income ETF (NYSE: JEPI). JEPI also advertises regularly on Fox Business News and MSNBC. However, the JP Morgan name doesn’t necessarily mean the ETF is for everyone. 

JP Morgan Equity Premium Income ETF

JEPI’s monthly dividend payouts and high-yield is the JP Morgan selling point.

The JP Morgan Equity Premium Income ETF is a fund that cherry picks solidly reliable dividend paying stocks from the S&P 500 Index. Unlike with some of its competitors, especially YieldMax, attention is paid to those stocks that are not overly volatile. It sells near-term out-of-the money calls. 15% of JEPI assets are used to package the calls into Equity Linked Notes (ELN) that serve as synthetic out-of-the-money calls against the portfolio of 120-130 stocks. The strategy is predicated on the stocks’ slow volatilities, with the majority of the ELNs expiring worthless. Thus, extra income is derived from the portfolio stocks beyond their intrinsic appreciation over time. The premiums earned from selling the options mathematically reduce the cost basis of each stock accordingly.  Other details at the time of this writing include:

The top 10 largest holdings in the JEPI are:

• Nvidia 1.87%
• Broadcom 1.75%
• Hownet Aerospace 1.75%
• Alphabet Inc. Class A 1.72%
• Amazon.com 1.68%
• NexEra Energy 1.66%
• Eaton Corp. 1.70%
• Trane Technologies PLC 1.61%
• Apple Inc. 1.60%
• Eaton Corp. PLC 1.59%
• Ross Sores 1.58%

The Good, The Bad and The Ugly

Like the characters of the classic Clint Eastwood western, JEPI has a mix of good, bad and ugly features that may appeal to some investors but turn off others.

Due to its somewhat complex structure, JEPI has benefits and risks that are unique. Retirees might find some of them attractive and be averse to others, depending on their individual risk profiles.

Good:

• A $10,000 investment in JEPI at its 2020 inception would be worth roughly $18,607 at this point in time. 
• The ex-dividend date is the first of every month, with payout to follow shortly after.
• Morningstar gives JEPI a favorable analysis with a 3-star Gold medal rating. 

Bad:

• Dividends are taxed as income, not as qualified dividends, which fall into a lower bracket.
• Covered Calls strategies, by design, put a cap on upside gains for each given month.
• ELNs involve additional counterparty risk, thus JEPI can be impacted if an ELN issuer were to suddenly undergo a financial crisis.
• NAV is at potential risk during a market downturn, so dividends may actually be a net return of capital. 

Ugly:

• JEPI has consistently lagged the S&P 500, especially during bullish runs led by the Magnificent 7 stocks. 
• JEPI historically lags behind index-based covered call ETF peers, putting JP Morgan’s active management expense fee into question. 

In conclusion, retirees should weigh the benefits and pitfalls of JEPI before plunging in. Prudent strategies might call for using JEPI as an adjunct to a bond portfolio, as opposed to a substitute.