Treasury bills look tempting right now, but a growing category of options-based ETFs promises a similar yield while keeping the IRS largely out of the picture. The catch involves a four-legged derivatives strategy most investors have never heard of.
This post may contain links from our sponsors and affiliates, and Flywheel Publishing may receive compensation for actions taken through them.
With interest rates on the rise again, Treasury bill ETFs are looking more attractive. The Federal Reserve recently raised its target range by 25 basis points to 3.75%-4.00%, making short-term government debt an appealing source of income in a higher-for-longer rate environment. T-bills also carry the credit backing of the U.S. government and minimal duration risk, giving investors a relatively low-risk place to earn competitive yields.
There is one drawback: taxes. Treasury interest is subject to federal income tax, although it is generally exempt from state and local income taxes. For investors in high-tax states such as California and New York, that exemption helps, but federal taxes can still create meaningful drag.
ETF issuers have developed a more sophisticated, albeit slightly more expensive, alternative: the box spread ETF. In a nutshell, these funds attempt to produce returns similar to T-bills while minimizing taxable income and capital gains distributions, by using a multi-leg options strategy designed to create a predetermined payoff at expiration.
How Does a Box Spread Work?
A box spread combines two options spreads with the same expiration date. One common construction consists of a bull call spread and a bear put spread. The fund buys a call at a lower strike price and sells another call at a higher strike. Simultaneously, it buys a put at the higher strike and sells a put at the lower strike. Put those four positions together and the payoff at expiration is essentially fixed at the difference between the two strike prices, assuming the options are European-style and held through expiration.
For example, a box constructed using strikes of 4,000 and 5,000 would have a predetermined expiration value of $1,000. If an investor can establish that box today for less than $1,000, the difference between its purchase price and its eventual payoff effectively represents interest earned over the holding period.
The strategy can also be constructed in reverse. One side of a box spread effectively lends money and earns an implied interest rate, while the opposite side effectively borrows money and pays that rate. Box spread ETFs are interested in the former: paying less today for a known payoff later. The exact options used can vary by fund. Strategies can involve index or ETF options, while FLEX options allow the fund to customize features such as strike prices and expiration dates.
In practice, investors don’t need to manage any of those four legs themselves. The ETF does the trading and continually establishes new box spreads as existing positions approach expiration. That creates something resembling a synthetic zero-coupon bond. The fund commits capital today, receives a predetermined amount at expiration, and earns an implied rate of return in between.
The potential tax advantage comes from how those options gains are realized and managed within the ETF wrapper. Rather than continually receiving Treasury interest, the strategy seeks to generate its return primarily through appreciation of its options positions. However, these ETFs cannot guarantee that shareholders will never receive a taxable distribution.
Three Box Spread ETFs to Consider
The dominant fund in this category is the Alpha Architect 1-3 Month Box ETF (BOXX), with approximately $14.5 billion in assets under management. BOXX targets the economics of one-to-three-month Treasury bills using box spreads. Its 0.1949% expense ratio makes it more expensive than the cheapest T-bill ETFs, but the fee remains relatively modest in its own right.
You also won’t find the conventional 30-day SEC yield that investors might expect from a bond ETF. BOXX isn’t primarily collecting bond interest, so a more relevant metric is the return implied by its outstanding options positions. Its current average yield to options expiration is 4.39%. Tax efficiency isn’t guaranteed. BOXX made a taxable capital gains distribution on Aug. 13, 2024.
Competition has also arrived. The Calamos Tax Aware Collateral ETF (CBOX) has grown to approximately $1.7 billion in assets and charges an even lower 0.14% expense ratio. It similarly uses box spreads to pursue tax-aware returns comparable to short-term fixed income. There’s also the Roundhill Box Spread ETF (XBOX), with approximately $369 million in assets. Its 0.1449% expense ratio puts it only marginally above CBOX and below BOXX.
For investors deciding among them, I’d focus on more than a few basis points of fees. Implementation, liquidity, the specific options used, realized tax efficiency, trading spreads, and each manager’s ability to minimize taxable distributions all matter. I’d also resist calling any of these funds a literal replacement for Treasury bills. A T-bill is a direct obligation of the U.S. government. A box spread is a derivatives position whose economics are designed to approximate a short-term risk-free rate and carries different operational, liquidity and counterparty-clearing considerations.
Finally, inside an IRA or another tax-advantaged account, much of the tax rationale disappears, and a cheap T-bill ETF may be simpler. For taxable investors, however, BOXX, CBOX and XBOX offer an interesting alternative to collecting ordinary Treasury interest every month. Just remember you’re paying slightly more and accepting considerably more structural complexity in exchange for the possibility of keeping more control over when the tax bill arrives.
Contact [email protected] for any questions or corrections.