This bond ETF is a bet on ‘higher for longer’ and uses options to find extra income

Published Fri, Aug 11 20231:03 PM EDTUpdated Fri, Aug 11 20232:49 PM EDT

Jesse Pound @/in/jesse-pound @jesserpound

Wall Street keeps pushing back its predictions for recession and interest rate cuts, but an ETF that combines Treasurys and options may provide investors extra income while they wait for the market outlook to clear. A growing number of investors appear to be trying to squeeze additional cash from long-term bonds with the iShares 20+ Year Treasury Bond BuyWrite Strategy ETF (TLTW) . The fund has raked in $259 million of new cash from investors over the past month, pushing its assets under management to over $654 million, according to FactSet. TLTW's option-adjusted yield — which takes the most recent distribution and annualizes it — was 7.64% as of Aug. 10. The fund's growing popularity comes as investors have started to shift away from ultra-short term Treasurys to longer dated bonds. But with some Federal Reserve officials warning of further rate hikes and others calling for a "higher for longer" period that would mean rate cuts are still far off into the future, investors positioning for a bond market rally could be in for a painful wait. "Investors are positioned for recession, inflation crash, and Fed cuts – evident from $31.7bn inflows to Treasury bond ETFs on pace for a record year … Long-term bond funds look increasingly vulnerable to a sharp move higher in yields," Bank of America ETF strategist Jared Woodard said in an Aug. 9 note to clients. Indeed, long-term bonds have greater duration, meaning their prices are more sensitive to changes in interest rates. "Popular Treasury ETFs, such as [iShares 7-10 Year Treasury Bond ETF ] and [ iShares 20+ Year Treasury Bond ETF ], could lose another 4-8% if yields spike by the end of September," Woodard said. The TLTW presents a strategy to thread the needle and offset declines in bond prices with income from selling call options. The fund works by buying the iShares 20+ Year Treasury Bond ETF (TLT) and then selling call options with strike prices roughly 2% above the market price of the underlying fund. Because yields and bond prices move in opposite directions, this options strategy means investors can generate additional income when yields are little changed or rise. The fund was one of three similar exchange-traded funds launched by iShares last year , with an eye toward a time when the central bank would be slowing its rate hikes. "The interest in the product is born of a view that if you are higher for longer and you believe rates either won't rally significantly or if they back up, you'd rather have this option income to cushion you," said Steve Laipply, global co-head of bond ETFs at BlackRock. The options component of the fund is structured to be rolled over on a monthly basis, and the cash generated by the options trade is passed on to shareholders. The fund uses European-style call options and closes them out prior to expiration, so the underlying TLT holdings will not need to physically change hands. So far, the strategy is working. The TLTW has outperformed TLT year to date, with a total return of 4.4% versus -2.2%, even though the underlying ETF rallied in January and March. *30-day SEC yield shown for TLT, option-adjusted yield for TLTW "TLT has a sufficiently high level of volatility that you can allow for some out-of-the-moneyness just to allow investors to participate in some of the upside if you do get a small rally," Laipply said. To be sure, the options structure does limit the upside of the fund in the event that yields fall and the TLT rises. The fund's yield is also variable, based on market pricing of the options and whether the call option trades ends up being successful. The TLTW also comes with a higher cost than vanilla Treasury funds. The fund has an expense ratio of 0.35%, which is net of a fee waiver that offsets the 0.15% paid for the underlying TLT shares, according to the fund's prospectus.