XYLD: Looking At 2023 After $3.86 Of Income Generated At 10.71% TTM Yield (NYSEARCA:XYLD)

Income-focused investment products continue to be introduced as firms bring products with option overlay strategies to the market. Options continue to increase in popularity, and I see more investors utilizing and discussing different option strategies as a part of their overall investment mix. Global X helped pioneer the space with the Global X S&P 500 Covered Call ETF (NYSEARCA:XYLD) which was introduced on 6/21/13. For more than a decade, XYLD has provided monthly income by writing call options on the S&P 500 index. The debate about investing for capital appreciation rather than income investing is one that will be debated for decades to come, as every investor is unique with different goals they are trying to accomplish. Call option strategies allow investors to turn premiums from writing contracts into immediate income. XYLD takes the independent work out of the process, allowing investors to buy a single investment product that owns the S&P, then writes call options on the index to generate monthly income. On a YTD basis, XYLD is up 0.53% and has a trailing twelve-month (TTM) yield of 10.71%. In 2023, the risk-free rate of return exceeded 5%, but investors could have generated double the yield with a side of minimal appreciation by holding XYLD as an alternative. While I like several income-focused products, XYLD is still implementing its strategy and generating substantial amounts of income for its investors. I think that XYLD will slightly appreciate in 2024 while generating high single-digit or low double-digit yields.

Following up on my previous article about XYLD

On October 10th, I wrote an article on XYLD (can be read here) where I discussed how the macro environment was unfolding, and how XYLD was one of my preferred alternatives to treasuries. As we are about to close out 2023, I am following up with this article to discuss XYLD’s 2023 results, its historical performance, and why I still like it as an income-focused investment for 2024. I have been bullish on XYLD for some time as an income investment, and I plan on adding more prior to a Fed pivot.

XYLD’s covered call approach has outperformed CD’s and Treasuries in 2023

Over the past 10 years the risk-free rate of return on the United States 12-Month Bill has increased by 4,043.76%. Back in January of 2014, investors were getting 0.12% by parking cash in a 12-Month Bill, creating little incentive to buy treasuries. Going into 2018, yields increased to around 2.75%, then started falling, and drastically declined back below 0.12% after the pandemic started. The Fed has increased interest rates at the quickest pace in several decades, which has made yields on the 12-Month Bill exceed 5% for the better part of 2023.

United States 12-Month Bill

As yields increased, we saw more capital flow into money market accounts. Some investors decided to wait for a better entry point to get back into the markets as the risk-free rate of return became enticing, with yields over 5%. If you had locked up capital at the beginning of the year in a CD or a T-bill you would have gotten close to a 5% yield, and if you had waited a bit longer, rates hit 5.25% in May. Investors hadn’t seen yields from risk-free assets at these levels since 2006, and capital gravitated toward them, considering the unknown. Geopolitical conflict was on the rise, inflation was still well above the Fed’s target rate, and the rate hike cycle was still increasing. There was tremendous uncertainty at the beginning of 2023, then the regional banking crisis occurred, and yields ended up going higher. A lot of investors weren’t prepared for the AI boom and big tech to lead the markets much higher coming out of the regional banking crisis.

XYLD started the year at $39.39 and has appreciated less than 1% to $39.60 YTD. While the underlying asset is barely up, it has generated a tremendous amount of income for shareholders. XYLD pays a monthly distribution, which is generated by utilizing a buy-write options strategy. XYLD will invest its assets in all the companies within the S&P 500, just like a traditional index fund on the buy side. XYLD then implements a sell-side where it writes or sells corresponding call options on the S&P 500. On a monthly basis, options are written at the money, and the premiums are utilized to fund the monthly distributions. The income generated fluctuates as premiums change due to market volatility. On a YTD basis, XYLD has generated $3.86 in distributed income, which is a 9.79% yield on its $39.39 share price at the beginning of the year. With one more distribution on the way, XYLD will probably exceed a 10% yield on invested capital for 2023 while slightly appreciating. This fund does all of the work for investors and has basically doubled the amount of income that could have been generated by hanging out in risk-free assets.

Just over a decade ago, XYLD IPO’d at $40 per share, and since then, its share price has settled at $39.60, -1% lower than the price at inception. For the majority of its time as a public ETF, XYLD has been above its IPO price and has recently been trading sideways after the market crash in 2022. A decade ago, the rate on a 10-Year treasury was 3%. Since its inception, XYLD has generated $31.58 in distributable income which is 78.95% of its initial share price. XYLD has been public for 10.42 years, making its average annual yield since inception 7.58% based on its original shares, which cost $40. This doesn’t include reinvesting the past 125 distributions and growing the share base. While XYLD’s share price and monthly distribution have fluctuated, its outperformed risk-free assets in 2023 and since its inception from an income perspective.

Why I think XYLD will do well in 2024

I think we’re going to see a market rally in 2024. There is $6.1 trillion in liquidity sitting in money market accounts. Investors who continued to allocate capital toward money markets aren’t necessarily serious about locking in long-term yields. Investors have had the opportunity to lock in a 2-year rate around 5.4% and a 10-year rate above 4.5%, but capital was stashed in money markets. This is capital that can be deployed at a moment’s notice, and I think that there are many institutions and individual investors that have been trying to squeeze out yield risk-free while rates are still high but are ready to redeploy capital when it looks like the Fed is going to cut rates.

We just got an unemployment print that fell to 3.7% as GDP expanded 3% YoY in Q3. At the latest Fed meeting, Jerome Powell acknowledged that inflation has retraced without a significant increase in unemployment, which is good news. If you are interested, you can read the entire speech by clicking here. He specifically addressed the individual assessments of the Fed members on what they felt the appropriate path would be going forward, and the outcome was that the median of the data points had the Fed Funds Rate at 4.6 percent at the end of 2024, 3.6 percent at the end of 2025, and 2.9 percent at the end of 2026.

As the Fed pivots, the risk-free rate of return will continue to fall, creating a less enticing environment to stay in risk-free assets. As rates move lower, so will the cost of capital, businesses will likely start to expand, and individuals will be more enticed to make big purchases that they have been holding off on. I think this will create an environment where capital will flow back into the capital markets from the sidelines, looking to recreate the yield investors are accustomed to and increased earnings as more capital gets allocated toward goods and services. I think that this will spark a broad market rally in 2024, which will be good for XYLD.

Risks to XYLD

While XYLD is an income play that utilizes the option market, there are still risks. If the overall market declines, then XYLD could see downward pressure. If volatility declines, then premiums could shrink and decrease the amount of yield that XYLD generates. If we go into a strong bull market, most of the upside will be capped, and XYLD will sit out of most of the market rally.

Conclusion

If you’re an income investor, then XYLD is still interesting. XYLD isn’t dependent on harvesting dividends to pay its distributions, and is able to manufacture a large yield by writing covered calls on the S&P 500 index. As the Fed pivots, I think a substantial amount of capital will pour into the market, and covered call ETFs will get more popular. I want to add to my position in XYLD as it’s created a decades-long track record of paying monthly distributions and has a TTM yield exceeding 10%. I am very happy sitting on the sideline, collecting my monthly distributions, and plowing them right back into XYLD without having to do any of the work. I think XYLD will continue to be a high-yielding ETF and that it can generate modest appreciation in 2024.