Using Derivatives to Capture Interest Rate Spreads - Part 2

by Wayne Ferbert on February 7th, 2014

We wrote about some new products we like from ProShares that capture the interest spread between different classes of fixed income: Treasury to Hi Yield and Treasury to Investment Grade. However, no product exists that captures the spread between Hi Yield and Investment Grade Corporates in the ETF space.
 
So, can we build it ourselves with options? The first thing you must be able to do is find a fixed income ETF in each category with a similar weighted average maturity and similar effective duration. These ETFs have to also have options. Ideally, these options will be robust and liquid.
 
This was not an easy challenge. Our favorite investment grade and hi yield funds are the LQD and JNK - the iShares iBoxx $ Investment Grade Corporate Bond ETF and the SPDR® Barclays High Yield Bond ETF, respectively. But we have a mis-match between the duration and weighted average maturity dates of the fixed income inside the funds.
 
LQD has a 7.5 effective duration and an 11.5 weighted average maturity. JNK has a 4.3 and a 6.7, respectively, in the same measures. In other words, LQD is much more sensitive to interest rate moves than JNK will be because it is further out on the curve.
 
Our problem: there are not any really good investment grade corporate fixed income ETFs with robust options markets except the LQD.
 
So, LQD has to be our hedge option as we want to be bearish the investment grade corporates with a small amount of capital – and the put market that exists on LQD should permit that. Our mission now: what Hi Yield ETF do we use?
 
I think we have two options: (1) we either use options on JNK and acknowledge the mismatch in duration OR (2) we purchase an ETF in the Hi Yield category with a better duration match to the LQD.
 
Believe it or not, there really are no meaningful high yield ETFs with a maturity or duration that are materially longer than the JNK. So, if we are going to do this trade, it will have to be option 1. We’ll discuss the risk of the duration mis-match later.
 
So, if you had a $100,000 portfolio that you wanted to use for this trade and you wanted to be equal dollar bearish and bullish using options, you would need to find how many shares of each ETF are needed to equal $100,000. For JNK, priced at $40.70, that is 2400 shares. For LQD, priced at $116.08, that is roughly 900 shares. These would be $98k and $105k, respectively. You want these amounts to be a close match. So, take the JNK up to 2600 shares.
 
That means each options transaction will be 26 contracts for JNK and 9 contracts for LQD. The trade is simple: you purchase 9 contracts of deep ITM puts for LQD and you sell 26 contracts for deep ITM put for JNK. You will notice that these deep ITM puts have a fair amount of time value. That time value is actually the discounted value of the dividends between now and the expiration of the option.
 
Both have options thru at least September of this year – so I recommend using the Septembers. I also recommend that you go deep enough in the money on the LQD put that the time value becomes the lowest it can be – to reduce your ‘short interest’ that you pay being bearish the LQD. I then recommend that you make the JNK similarly deep ITM in size (ie, % ITM).
 
An example today would be: purchase the September $120 puts on LQD for around $7.20 and sell short the September $43 puts on JNK for around $4.10. If you do this in a margin account, the total buying power used will be less than $30,000 – but you will have effectively created this spread trade for a $100k portfolio.
 
When you collect the premiums for JNK, you are collecting ~$4700 in time value (ie, discounted dividends) and for LQD, you are paying ~ $3000 in time value. So, you net $1700 in discounted dividends on a $100,000 position for a 7 month expected hold time. That will be roughly a 3% annualized return – effectively the annual spread between these 2 products.
 
So what are our risks? Fixed income has interest rate risk and credit risk. Let’s discuss the interest rate risk since the mis-match comes in to play here. If interest rates move up, the price of both bonds will go down. But the LQD should go down more in value because it is further out on the duration curve. If rates go down, then LQD will increase in price more than JNK on a relative basis – for the inverse reason of rates going up. The LQD is just more sensitive to interest rate moves.
 
The net/net on interest rates: if you think rates are headed higher because the Fed is going to push them higher, then you should like this trade.
 
The other risk is the credit risk.
 
Is the credit risk in this example hedged in any way? Not if you are just bullish Investment Grade and bearish on High Yield. Look at the credit crisis from 2008/09 in the chart below. You can see that at their worst, these two deviated in price during the early 2009 market plung by 30%. That woule show up in the price of this trade also. The price performance in these two funds deviated significantly in 2009.
So, if you make this trade, you must believe that there is no credit crisis looming. Remember that a credit crisis will always hurt the junk bond category worse than it will hurt the investment grade category.

If you are really worried about the credit crisis event, you could purchase a deep OTM put on JNK between $30 to $35 strike price. This should cost you less than 25 cents or roughly 1% of the annual spread. But that might give you the comfortable feeling of knowing you have a floor in the event of another 2008 credit event.
 
Overall, this trade isn’t perfect – but as long as we avoid a credit crisis, this trade should clip a reliable 3% annual return with fairly low volatility. In addition, the trade is poised to make additional returns from any increase in interest rates!


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