Beat the Bond Market With Lower Risk Using Options

When investing in fixed income, investors are in search of income while enjoying capital security. Furthermore, the negative correlation of this asset class with the stock market can also provide significant benefits to the diversification of a portfolio.

One of the major disadvantages of fixed income in a non-registered account is associated with the heavy tax burden on interest income. In the current environment where rates are low, net income after taxes of this portion of the portfolio can be very thin.

With an asset under management of $1,97 billion, the iShares DEX Short Term Bond Index Fund -XSB is among the most widely used financial products in Canada to invest in fixed income. It provides income by replicating as closely as possible the return of the DEX short term bond index. Its weighted average yield to maturity on February 8, 2011 was  % while its share was trading at $ . In a context where the economic consensus expects a gradual increase in the rates, the investor in this bond index could, however, deal with disappointing returns.

The Montr�al Exchange offers the ability to trade options on XSB. A strategy of selling puts (PUT) could be extremely beneficial to increase after-tax returns while reducing the risk of holding the security directly. Let's see why :

On February 8, 2011, the bid price of the $28 PUT for the month of September was $   per contract.

Premium paid to the seller: $ 

Premium yield (XSB trading at $ )  % Maturity: 7 months

Annualized return of premium  %

Note that the annualized return of premium ( %) corresponds closely to the weighted yield to maturity of XSB ( %). However, the options strategy remains much more favorable because of the following elements:

� Money left in cash to guarantee the sale of the $28 puts may be invested in a high yield bank account or money market funds offered with most Canadian brokers. The current average yield of this type of account varies from  % to  %.

� The premium received with the sale of the PUT is considered capital gain. Only 50% of this gain is taxable as opposed to 100% for interest income.

� The strike price of the option is $28 or  % below the current price of $  . This provides a buffer against an important decline in the price of XSB, a likely phenomenon associated with rising interest rates (because bond prices tend to fall).

Here is a comparison according to the scenario where XSB and interest rates remain stable until September (option expiry):

XSB sept 28$ PUT selling

XSB

Premium paid

0,40 $

XSB price

28,73 $

XSB price

28,73 $

Premium yield (7 months)

1,39%

Annualized yield (capital gain)

2,39%

Interest yield equivalent

3,58%

Weighted average yield to maturity

2,40%

Cash interest return(BTB Trust High Yield Savings Account)

1,35%

Cash interest return(BTB Trust High Yield Savings Account)

N/A

Interest yield equivalent

4,93%

Interest yield

2,40%

Option strategy annual advantage

+2,53%

Finally, here is the performance of the strategy for the following scenarios:

XSB price at option maturity

% down

Option Strategy annual return

XSB annualized net return

Strategy advantage

28,50 $

-0,80%

4,93%

1,60%

3,33%

28 $

-2,54%

4,93%

-0,14%

5,07%

27,5

-4,28%

0,65%

-1,88%

2,53%

To conclude, a strategy of selling puts on XSB options allows:

� A significant increase in the expected return from an simple buy and hold of XSB

� An important risk reduction against an XSB price drop in the event of interest rate rise

� Providing a higher return on cash in the event of a rate hike

Since XSB is a big player in the fix income segment, investors that do hold this position might want to consider the use of this options strategy since it's risk/reward characteristics are better than a simple buy and hold position. 



 

At  , we believe that trading options can give an edge to the overall performance of investors
 Educate and expand options trading knowledge to improve your trading skills
 Remove emotions from the investment process 

For more information, please visit: High Yield Money Market
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