As bond rout worsens, a trade Wall Street uses to replace them booms in popularity
If the U.S. Treasury bond market has 99 problems, the surge in popularity of a particular type of options trade may be the one that gets talked about the least.The options strategy, commonly referred to as a "box spread," combines four options at two strike prices: one bullish call spread and one bearish put spread — mostly on the S&P 500 Index — to create a market-neutral position whose price at execution becomes cash received by the seller, or borrower, and whose fixed value at expiration is the total amount received by the buyer, or lender. The difference between the two represents the "interest" paid to the lender.It's as close to risk-free income as the derivatives market has to offer, with a bonus: because it's an equity-derivative product, it falls under the lower tax category of capital gains versus interest income.The value of open box-trade loans on S&P 500 options hit an all-time high of $146 billion last Friday, according to Cboe Global Markets data compiled for CNBC. Average daily notional value traded was more than $2.3 billion last month, up 26% from a year ago, with retail traders accounting for $54 million on a daily basis.Right now S&P box spreads yield an income of more than 4.4% using contracts expiring in three months. That compares to under 4 percent in three-month Treasuries and about a 3.9% overnight SOFR rate.
"We've seen an uptick in use by ETF sponsors, wealth advisors, and even some larger retail accounts who have found the effective interest rates beat their alternatives on both the lending and borrowing side," Henry Schwartz, VP of Derivatives Market Intelligence, said in an email.Once considered a clever but complex strategy reserved for high-end institutional clients and the biggest banks, the trade has gone mainstream as exchange-traded-funds package the trade into their low-cost vehicles and the investing public and advisors get more comfortable with options-based strategies.Total assets under management of at least three ETFs tracking the trade – the biggest being Alpha Architect's $15 billion 1-3 Month Box ETF (BOXX) – is about $20 billion.
While the dollar amounts might pale in comparison to the $30 trillion dollar U.S. Treasury market, the growth of box spreads speaks to the increasing savviness of financial advisors and individual investors looking for alternatives to traditional fixed-income assets, and what they call "tax-aware" strategies. It also arguably adds pressure to the Federal Reserve to bring interest-rates higher to compete with what's on offer in other asset classes.There may be one catch: the bigger the trade gets, the more the government is paying attention. In July, the Treasury department said it is eyeing investment strategies aimed at dodging U.S. tax rule. Box spread funds, alongside other tax-minimizing strategies used by advisors, are being looked into, according to Reuters.
No new rules have been issued regarding the trade, but some bond watchers wonder if the growing popularity of the trade might siphon capital that would otherwise be allocated to the bond market. "Box spreads have been around for ever but volume is picking up for all kinds of options so liquidity is no longer restrictive," said one financial advisor who asked to stay off-record until the government makes its position clearer on box ETFs. "You can use different iterations of derivatives which historically would have been more likely to go to fixed income or cash."
