ZBIG Update: Adjustments to Fixed Income Component on Closer in Maturities
By Jay Pestrichelli
I wanted to post an update as some of you may notice some adjustments in the positions located within the ZEGA Buffered Indexed Growth (ZBIG) strategies. While many accounts may not have any changes in whole or part, others which have options expiring in 2020 or earlier will be impacted.
What Is the Change?
The change being implemented this week is a rotation out of the Bullet Share ETF and into a treasury position coupled with an option premium selling strategy. The pairing of these two positions aims to produce similar returns as the Bullet Share dividends while managing the risk associated with the high yield market.
To accomplish this, we will be using short put spreads on a high yield ETF: HYG. As mentioned earlier, we’ll be purchasing some US Treasury bonds with a less than one year duration in these accounts to create a blended fixed income position.
As a review, ZBIG consists of a stock market exposure with call options (and sometimes put spreads) that replicate long ownership in the S&P 500 index. The income portion of ZBIG accounts has historically been constructed using Invesco’s Bullet Share ETFs. The goal of that position was to deliver a yield via monthly dividends to help cover the cost of the long call options over the maturity of the position.
The difference now is that we will generate the income not from dividends but from the extrinsic value in the spreads along with treasury yields. The HYG spreads will synthetically produce returns that act much like a dividend would. Option spread position have a defined loss. This also let us shrink the max drawdown over the period between entry and expiration. All the while delivering the strategy’s income goals of offsetting the long call costs.
For accounts with option expirations 2021 or later, nothing will change for now. We will off course continue to monitor those accounts to see if any adjustment is warranted.
Why the Change?
We thinks it is the right time due to the difference in yields between the interest rate on high yield bonds and treasury bonds shown below in the graph. It is an illustration that tracks the difference of the yield on high yield bonds minus the yield on treasuries and plots in on the graph.
Source: FRED Federal Reserve Bank of St. Louis
When the line is lower, it means there is less of a difference. Typically, when yields spike on High Yield, it means that high yield has sold off to the downside a bit. These interest spreads have been narrower of late compared to the spike in late 2018, early 2019. In other words, the narrowing may reverse, and this is typically damaging to the high yield market.
By moving to the synthetic position using options, we can lesson some shorter-term volatility in the portfolio given that the maturity on our target portfolio is closer in. It also creates a synthetic hedge on the high yield positions at the same time.
What Other Potential Benefits?
In addition to meeting our income goals for accounts this move creates a potential reduction to reduce the risk of short-term high yield. Should high yield experience a short-term drawdown, the spreads provide a limit on the position’s loss otherwise known as a hedge.
In addition, market sell-offs may provide an opportunity. The accounts now have a defined risk on these positions, if a drawdown is large enough, we may be able to realize less of a short-term loss on the spread positions compared to the Bullet ETF’s and then re-acquire Bulletshares at lower levels. Being able to buy in again at lower levels also implies that the annual yield will be much higher.
When will this change take place?
ZEGA’s traders have already been opportunistically been rotating positions within accounts. As we mentioned earlier, this is just for maturities 2020 and earlier. Further out maturities should be unaffected at this time. If you are among those with 2020’s, you’ll start seeing the HYG spreads and treasuries show up in accounts and transactions will be noted on your statements.