Option Enhanced Bond Yields

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 |  Includes: IEF, MBB
by: Surly Trader

At a time when short-term interest rates are near zero percent and long-term rates are historically low with expectations of rising rates in the future, it is tough being a fixed income investor. You are damned if you sit on cash and you might be damned if you lock up money in 30 year Treasuries at 4.65% going into an inflationary environment that could rival the early 80′s. The key for most, including Bill Gross at PIMCO, is to invest somewhere in the 0-10 fixed income space and make up for a lack of interest rate yield by going into bonds with higher credit risk. I will not argue whether high yield bonds are a good place to park money, but I will argue for a relatively safe alternative.

One rather safe alternative to Treasury securities are agency mortgage backed securities which can be purchased rather cheaply through the iShares Barclays MBS Bond ETF (NYSEARCA:MBB). The fund has an indicated yield of 3.7%, fee of .33% and weighted average life of 4.44. This is basically a portfolio of many callable mortgages primarily backed by the U.S. government. So what would be an alternative?

What if we purchased Treasuries and wrote call options on those Treasury securities. You will still receive your coupon payments, but you can supplement the coupon payments with option premium. If the Treasury bond’s price rises, you might get called away on that security, but at a price level above the current price while collecting the option premium. As an example, let us consider the iShares Barclays 7-10 year Treasury ETF (NYSEARCA:IEF). The ETF has an indicated yield of 2.81%, .15% fee and weighted average maturity of 8.71 years. What happens if we turn this ETF into a callable bond ETF?

(Click to enlarge)

So let us run through the scenarios:

  • Under flat pricing on the IEF fund with consistent call writing through the year, you would expect to receive 6.68% in income through the year as a combination of the 2.81% of Treasury bond income and 3.9% of call option premium received.
  • If Treasury yields fall and the price of IEF rises, then you will get called away at $93 plus the $1 option premium for an effective sales price of $94. With dividends received that equates to a 2.64% return in 3 months.
  • If Treasury yields rise, then you are protected by the $1 of option premium received. If IEF falls further than $1.79 (option premium plus dividends received) then you will start losing so your breakeven price is $90.56.

For an investor looking for income but fearful of credit spreads widening, rising interest rates, falling stock prices or a combination thereof, I think this strategy makes a lot of sense. The profile of this strategy can also be changed depending upon the investors outlook. e.g. If you believe that rates will rise more rapidly, then you can write the call option slightly in the money.

Disclosure: I am long IEF.