Managing your Fixed Income ETF Hedges

by Wayne Ferbert on January 9th, 2012

The fixed income ETF space has been a real growth engine for the ETF marketplace. In the ETF landscape, it is still growing in terms of both new issuances and asset growth in existing funds. The first Fixed Income ETFs weren’t issued until 2002 – but the space is on pace to eclipse the $200 billion AUM mark sometime in 2012. On Dec 31st, the total AUM in the space was $177 B – which included $41B in new asset flows.

With the popularity of these funds, you can bet that more and more fixed income ETFs will start to have options that trade on them. There are some very healthy options markets for a handful of fixed income ETFs – LQD and JNK come to mind. But it would be nice to see some more. As these ETFs grow, expect that the exchanges will make sure that options are produced on the largest ones.

At Buy And Hedge, we like to use options to protect our downside. We also use fixed income in a maturing portfolio to lower the portfolio volatility and add an asset class with low correlation to stocks. For the fixed income ETFs with a liquid options market, the options chain can tell you a lot about what the market thinks about the fixed income inside your ETF.

A fixed income ETF is effectively a fixed income ladder with a targeted average maturity and a targeted credit rating. As a near-date bond matures, the capital redeemed is re-invested in a bond to keep the average maturity near the target. And the re-investments must be made in the bonds that meet the prospectus’ target credit worthiness.

So, the price risk to a fixed income ETF is really driven by two factors: interest rate risk and credit risk. The market consensus on these two factors will drive the prevailing price of the fixed income ETF. The options markets will reflect the market’s price consensus also – as it always does.

Of course, fixed income ETFs have significant dividend flows – which also factor in to the options pricing. I like to examine the put market for fixed income ETFs to really get a feel for what the market thinks about the forward price risk for any particular class of fixed income.

I like to start with the At-the-Money (ATM) puts for the fixed income ETF for around 6 months out or even 1 year out if that month has been issued yet. I then compare the cost of that put protection to the dividends that are expected to be paid by that ETF between now and the expiration of that put.

In a declining interest rate environment, you expect fixed income prices to increase. As a result, the put market for fixed income ETFs tends to trade at a discount when this occurs. In fact, there have been examples when you could have found puts that were at-the-money for Fixed Income ETFs that were trading for about the same as the dividend you’d expect to collect between now and expiration. In other words, you could trade your dividend in for no downside risk in the fixed income ETF. Or think of it this way: you have no downside risk in your fixed income ETF but you have all of the upside price opportunity.

Of course, the inverse is true in an increasing interest rate environment. When rates are increasing, the price of the fixed income investments is expected to decline. Any time that prices are expected to decline, the put market will trade at a premium. You will see that in the put prices for fixed income ETFs.

So, how do you explain this current market and what the puts are telling us? Let’s look at the LQD – an investment grade fixed income ETF. It has a fairly liquid ETF market. The farthest month is the June contracts. The at-the-money June puts ($113) are trading at about $3 per share. Between now and June expiration, the dividends collected will be about $0.40 per month – 5 times $0.40 equals $2.

The result here: your dividends will not offset the cost of the put – and you’ll have to pay an extra dollar for protection for a little over 5 months. That is about 2% cost for protection above the dividend cost for investment grade fixed income. That price seems steep. It seems to imply that the market thinks that the risk of the fixed income going down is real.

What would cause that price decline? The answer: An increase in interest rates or a decline in the credit quality. You won’t find a lot of economists that believe that interest rates will meaningfully increase in the next 5 months. But interest rates can’t go much lower so I think the signal here is that the market is going to make you pay for protection when clearly the interest rate environment is at or near its floor. And with uncertain global credit market, insurance protection for fixed income has to come at some cost.

The net/net if you are a Buy And Hedge investor: married puts to fixed income ETFs can be set a little lower than the ATM price – and consider selling some covered calls against the ETF also to generate some extra income. After all, the bias is clearly towards a downward pricing for fixed income. Add to that the fact that interest rates are near their floor. So, upward price pressure on fixed income seems unlikely. Take advantage and grab some covered call income.

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