Treasury Bill yields have been trending lower since late July as interest rate cuts started to be priced into the market. Yields eventually dropped below the psychologically important 5.00% level (see Figure 1) that had many investors hanging out in money market funds for the past couple of years. Then the Federal Reserve Bank (FED) cut the Federal Funds Rate by 50 basis points (bps) — or 0.50% — at their September meeting, beginning the start of an easing cycle that sent Treasury Bill yields even lower. The expected path forward is a series of interest rate cuts, to bring down the Federal Funds Rate to a more neutral level, and thus Treasury Bill yields should continue to decline. Over $6 Trillion invested in money markets are now searching for a new home and will suffer reinvestment risk the longer an investor waits. In this Fund Insight, we introduce a yield-enhanced Treasury Bill strategy as a cash alternative for those investors still looking for attractive yields without credit risk now that front-end yields are falling.
Figure 1: U.S. Treasury Bill YieldsSource: Bloomberg
Yield-Enhanced Treasury Bill Fund
The Simplify Treasury Option Income ETF (BUCK) is a yield-enhanced Treasury Bill fund. This ETF looks to maximize Treasury Bill total returns while targeting a duration of one year or less and additionally looks to enhance yield via structural alpha by selling options on Treasuries. The potential yield target is 2.00% to 3.00% higher than the Bloomberg U.S. Treasury Bill: 1-3 Months Index. The fund is actively managed, investing at least 80% of its net assets in U.S. Treasury securities, and enhancing income through a risk-managed option selling strategy. The risk-managed options writing strategy is designed to provide additional income as well as add to the ETF’s total returns.
Risk-Managed Options Writing Strategy
Treasury options are consistently in high demand for broker-dealers — especially those involved with Mortgage-Backed Securities (MBS) — to hedge out interest rate risk. This strong structural demand to buy options naturally increases option premiums, adding to the potential profitability of option-selling strategies. By selling out of the money options at key rate levels, BUCK generates additional income while positioning for adding or reducing risk at high reward-to-risk junctures.
Strike prices in BUCK are typically selected with about a 90%-to-95%-win probability that the options expire worthless. Additionally, option durations are short, typically one to two months to expiration. And finally, our risk management procedures will typically close an option early if the position goes in the money because once an option price goes through the strike price, the move in the option price accelerates rapidly.
Favoring Treasury Volatility Over Credit
In our view, option-based convexity risk is much more compelling than credit risk right now given that the MOVE Index (created by Simplify’s very own Harley Bassman), is extremely elevated (see Figure 2) and credit spreads are very tight (see Figure 3).
Figure 2: MOVE Index Remains Elevated, Ripe for Harvesting VolatilitySource: Bloomberg
Figure 3: 5-Year Investment Grade CDX Index Credit SpreadsSource: Bloomberg
Conclusion
After both a strong jobs report and inflation report for September, the market has repriced interest rate cuts to be more in line with the FED’s September Dot Plot, forecasting 150bps (1.50%) of cuts by the end of 2025. This should lead to a more gradual reduction of front-end rates, potentially keeping rates range-bound. However, rates are expected to be volatile within the range, as we have seen over the past month, creating opportunities to optimize convexity risk premium via option selling.
Most ultrashort duration strategies will enhance yield via credit risk; however, that is not very compelling right now given that credit spreads are very tight. Convexity risk is more compelling, and BUCK seeks to monetize the premium in an optimal way. Investors looking for a cash alternative and willing to accept a small amount of volatility while seeking the highest total returns with an enhanced yield without credit risk should consider an investment in BUCK.
GLOSSARY:
Basis Points (bps): A common unit of measure for interest rates and other percentages in finance. One basis point is equal to 1/100th of 1%, or 0.01%.
Convexity: A measure of how the duration of a bond changes as interest rates change. The greater the convexity of a bond, the greater that change will be for a specific interest rate shift.
Credit Spread: The difference in yield between two debt securities of the same maturity but different credit quality.
Duration: A measure of the sensitivity of the price of a bond or other debt instrument to a change in interest rates.
In the Money: An option that possesses intrinsic value. An option that's in the money is an option that presents a profit opportunity due to the relationship between the strike price and the prevailing market price of the underlying asset.
Option: An option is a contract that gives the buyer the right to either buy (in the case of a call option) or sell (in the case of a put option) an underlying asset at a pre-determined price ("strike") by a specific date ("expiry"). An "outright" is another name for a single option leg. A "spread" is when options are bought at one strike and an equal amount of options are sold at a different strike, all at the same expiry.
Out of the Money: An option has no intrinsic value, only extrinsic or time value.
Mortgage-Backed Securities (MBS): Investment products similar to bonds. Each MBS consists of a bundle of home loans and other real estate debt bought from the banks that issued them. Investors in mortgage-backed securities receive periodic payments similar to bond coupon payments.
