EOS: Covered Call CEF Generates Steady Yield With Monthly Pay-Outs

Eaton Vance Enhanced Equity Income Fund II (NYSE:EOS) is a closed-ended equity mutual fund (CEF) that invests in growth stocks of mid-cap and large-cap companies in diversified sectors. It also generates current earnings from selling call options on a substantial portion of its portfolio. This covered call strategy enables the fund to protect itself from unprecedented loss. During the past 10 years, the fund has generated steady yield in the range of 5 to 10 percent, supported by a strong price growth in the longer term. However, during a few calendar years, the price return was highly negative.

EOS’s Portfolio and Benchmark

Eaton Vance Enhanced Equity Income Fund II was launched and is managed by Eaton Vance Management. This fund was formed on January 31, 2005 and is domiciled in the United States. It benchmarks itself against the Russell 1000 Growth Index, the CBOE S&P 500 BuyWrite Index, and the CBOE NASDAQ-100 BuyWrite Index. However, unlike those indices, EOS holds only 60 stocks. Thus this fund fails to achieve the advantages of a higher degree of diversification. Also, almost half of its portfolio is invested in information technology and communication stocks. Almost 40 percent has been invested in seven large-cap technology stocks, namely Microsoft Corp. (MSFT), Alphabet Inc. (GOOG) (GOOGL), Amazon.com, Inc. (AMZN), Apple Inc. (AAPL), Adobe Inc. (ADBE), Qualcomm Inc. (QCOM), and Intuit Inc. (INTU).

These stocks are highly volatile these days, and thus the fund possesses a higher degree of price risk. This fund also fails to outperform its benchmark in most cases, due to its writing of call options. It receives the option premium and gains only in case the spot price does not cross the exercise price. As the writer of the call option of a particular stock expects the price to either remain flat or move down, the price growth of that particular stock gets neutralized by its exposure to the call option. Thus, over the long run, this fund will typically under-perform its benchmark. However, a good thing about this fund is that it doesn’t utilize any leverage. As a result, this fund is less riskier than the leveraged funds during times of panic selling.

Technology Stocks Performing Poorly This Year

Despite the covid-19 pandemic, technology stocks performed relatively well during 2020 and 2021. From April 2020 to December 2021, NASDAQ 100 Technology Sector (NDXT) had performed quite well, and recorded positive growth in 16 out of 21 months. Negative growth in the remaining 5 months was also marginal. However, in 2022, barring July, all other months have witnessed negative growth. Barring AAPL, the other six stocks mentioned above, generated negative growth during 2022. Both MSFT and ADBE recorded a negative growth of 32.5 percent. INTU fell by 29 percent, QCOM fell by 26 percent, GOOGL by 24 percent, and AMZN by 23 percent.

GOOGL was a victim of negative publicity at being caught sharing user data with a sanctioned Russian company. MSFT suffered due to loss of exports that resulted from strengthening of the US dollar. ADBE suffered due to rising inflation and low level of consumer spending. The e-commerce behemoth AMZN was done in by the rising cost levels. Increase in oil-price and supply chain breakdown due to the war in Ukraine had a major impact on the mega-cap technology giants. QCOM and INTU are also facing the negative impact of a depressionary market situation, although there are no significant changes in fundamentals. All these led to a price fall of Eaton Vance Enhanced Equity Income Fund II. However, I feel these bearish trends will be over within a few months and come back to its long term growth trajectory.

Advantages and Disadvantages of Covered Call CEF

In a covered call strategy, investors sell call options on stocks that they are holding and receive an upfront option premium, for undertaking the downward risk potential in the call option. These option premiums generate cash flows which create additional income. Investment management firm BlackRock says “that by using an equity covered call strategy, investors can reduce portfolio volatility by capturing option premiums, without having to sacrifice long-term performance.” Covered call CEFs also have the potential for higher risk-adjusted returns as compared to an equity only portfolio. Distribution rates for funds like EOS are also generally higher than rates of equity-only funds, as writing options generates cash flow that can help support a fund’s distribution rate.

Investment Thesis

Eaton Vance Enhanced Equity Income Fund II has been a good fund with a monthly pay-out and reasonably strong yield. It has been delivering consistent monthly distributions to shareholders since its inception in 2005, despite facing the 2008 global financial crisis, and covid-19 pandemic. Writing call options on half of its entire portfolio has made it easier for this fund to offer a steady monthly yield. This is again supported by a positive price growth over the longer time horizon. With the fund falling for the entire year of 2022, now might be a time to buy this stock.

There are chances of this fund moving further south, but it seems promising over the longer time duration. Despite a short-term bearish outlook of the market, these stocks seem to be slightly over-sold. Because stock prices are usually driven by a company’s financial performance over the long term, I am hopeful about the major technology stocks, which are the prime drivers of EOS’s portfolio. There is no significant threat to the technology sector. All these companies are investing heavily and poised for growth in future. Thus, people seeking steady monthly pay-out and stable growth in the long run can accumulate this fund.

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