Covered Call Funds - Just like Junk Bonds

You've probably heard of covered calls as a great way to earn extra income in your investment portfolio. They aren't exotic, it just involves selling options on your stock or index to guarantee small, frequent returns while cushioning your downside.

The more gradual the move, the better your relative performance. During steep market moves, your losses will be nearly the same during a crash, and your gains during a fast moving rally will lag by a large margin.

One example covered call fund is PBP. This ETF sells calls on the S&P 500 index. Here is its performance from December 2007, when the bear market was getting underway. PBP predictably outperformed the index through the crash, and underperformed in the recent rally, slightly beating the S&P 500 since the bear market inception.

While covered calls can have a place in your portfolio in range-bound and bear markets, they are not a good substitute for bonds in your portfolio, as was suggested a recent WSJ article. Covered call funds should be seen not as a conservative yield play, but an increased risk exposure play. In fact, covered calls are highly correlated to high yield bonds, as seen here when comparing the covered call funds PBP and BEP with the high yield bond fund HYG:

Covered calls have performed almost identically to high yield bonds. When looking into covered calls, it is best to consider if you want more or less of your portfolio in high yield bonds.