Tahoe-Truckee Market Beat: Combining treasury bonds with index options
At the last FOMC meeting, Janet Yellen indicated that the Fed would likely continue with gradual interest rate increases throughout the year. A return to more normal interest rates will be a benefit to conservative investors and savers.
Currently, the yield on the benchmark 10-year US Treasury bond is almost 2.4%. Normally, the 10-year Treasury will yield between 4.5% and 5.0%.
So, if you’re fortunate enough to have a million dollars saved up, in a normal interest rate environment you could obtain an income of $45,000 to $50,000 per year by investing in low-risk, 10-year Treasury bonds that are backed by the full faith and credit of the United States Government.
Today, the same investment would yield less than $24,000 per year.
A popular strategy in a more normal interest rate environment is to combine US Treasury bonds with index options. The way it works is pretty simple — invest some funds into Treasury bonds and use the income produced by the Treasuries to purchase call options on a broad based stock index.
By doing that, you have the ability to participate in the upside of the stock market, but you are limiting your risk to the premium you pay for the stock index options, unless the US government were to default on its debt.
So, if you invested $1 million in 10-year US Treasuries today, you’d receive about $24,000 over the next year to purchase options with. If you wanted to use the S&P 500 as your index, there are a variety of options contracts available that would get the job done.
One way would be to use the options on the Spyder, the SPY. The Spyder is an ETF that tracks the S&P 500 index. The options on the Spyder are very liquid. You could also use index options on the SPX. SPX options are also very liquid.
The index options have a couple of advantages over the ETF options. One is that they settle in cash instead of the underlying ETF. They also have a tax advantage; they are considered section 1256 contracts under the Internal Revenue code, and if you have a profit, most of that profit will be treated as a long term capital gain regardless of how long you hold the position.
Remember, options are not for everybody, and it is very important to understand the risks associated with them.
Kenneth Roberts is a Truckee-based Registered Investment Advisor. Information is at his blog at http://www.sellacalloption.com or 775-657-8065. The mention of securities should not be considered an offer to sell or solicitation to buy investments mentioned. Consult your investment professional to understand the risks and/or how the purchase or sale of these investments may be implemented to meet your investment goals. Past performance is no guarantee of future results.