Emerging Opportunities for Income

Emerging Opportunities for Income

BY DAVE DONNELLY

With the Federal Reserve’s steady march toward normalized rates at the front end of the yield curve, U.S. Treasury yields on 1- and 2-year maturities have risen from next-to-nothing, to a potentially interesting baseline for investment. Today, the 2-year Treasury pays an annualized income of 2.53%*, 118 basis points higher than this time last year.

Another intriguing development over the last twelve months is the upward shift up in volatility. February brought an extremely significant, and by some measures record-setting, event in equity volatility, with the VIX index (often referred to as the market’s fear gauge) spiking from 10 to near 50 in just two trading days. Those levels of volatility had not been witnessed since August 2015, and prior to that, the U.S. debt downgrade of 2011.

Assuming the Fed continues to raise rates, the opportunity for investors to generate interest income via short-term U.S. Treasuries is better than it has been in many years. Additionally, higher levels of volatility also provide new areas of opportunity for income generation. The best, and often overlooked part, is that these approaches can be used together.

By combining a portfolio of shorter-term U.S. Treasuries with an out-of-the-money put selling strategy, investors can generate returns in two ways. First, from the newly-interesting Treasury yields collateralizing the portfolio, and second, from increased premiums available from selling out-of-the-money put options.

Selling put options, particularly domestic equity index options, is a potentially interesting new source of income and it also offers the benefits of favorable tax treatment (60% long-term capital gain / 40% short-term capital gain pursuant to Internal Revenue Code Rule 1256), targeted equity exposure, high liquidity and a source of structural alpha. Investors have the potential of adding income to their portfolios in the current range of 300-600 basis points annually, in addition to the interest income on their 2-year Treasury holdings, while only exposing themselves to an estimated equity beta of 0.2-0.35.

Risks to this strategy include being exposed to a major downdraft in equities. For example, in today’s market conditions, if an investor sold a 1-year, 10% out-of-the-money put in the S&P 500, and they collected approximately 3.4% premium for it, they could lose money if a year from now the market was down by more than 13.4%. A deeper decline in the market could generate losses that would be on pace with a standard long only equity position.

Selling equity index puts against a portfolio of Treasuries is a strategy that capitalizes on the most critical developments in capital markets over the last year, namely, that short-term yields have risen, as has equity index volatility. Today, advisors and investors have a great opportunity to put these increasingly favorable tools to work in conjunction to generate yield. With a backdrop of historically tight credit spreads, equity markets that have performed extremely well, and a proliferation of illiquid debt products, this “paid two ways” approach to put writing may prove to be a worthy consideration.

 

Dave Donnelly

ddonnelly@spiderrockadvisors.com

(312) 256-9665

*As of 6/25/18