One of the primary concerns with any high yielding asset is how its price will be affected by rising interest rates. For bonds, this sensitivity is measured through the duration. Long-term bonds generally have higher duration and are more affected by changing rates. Assets other than bonds are affected by a variety of factors like credit spread, the state of the economy and the speed of the interest rate change.
In the previous two posts, we discussed buy-write and put-write strategies, which are both ways to generate attractive yields and are available as ETFs. However, with these high yields, what is the impact of rising rates?
Rates and Options
Both buy-write and put-write strategies hold short option positions. The sensitivity of an option to changing interest rates is embodied in the option’s rho, one of the Greeks along with delta (stock price), gamma (change in delta), theta (time to expiry) and vega (volatility). Rho is often swept under the rug because the other sensitivities are generally much larger.
This is also in the case with these strategies. The following chart shows the rho for a short position in a call and put with a 10 bps risk free rate, 2 months to expiry and 20% volatility.
The graph shows that the rho for the short calls is always negative while the rho for the short puts is always positive. Intuitively, we can reason this out by realizing that the holder of a call option has to effectively pay the strike price at expiration to buy the stock if the call expires in the money (this is a simplification since some options may settle in cash). The holder of the call wants the present value of the potential future payment for the stock to fall, which will happen when rates rise. Therefore, when rates rise (fall) the price of the call will rise (fall), benefitting the call buyer (writer).
The same intuition can be used to understand the negative rho of the short put position. The holder of a put option will receive the strike price at expiration in exchange for the stock if the put expires in the money. The holder of the put wants the present value of the potential future cash receipt to rise, which will happen when rates fall. Therefore, when rates rise (fall) the price of the put will fall (rise), benefitting the call writer (buyer).
Rising Interest Rates and Strategies
This chart paints a good picture for buy-writes and put-writes since the options are written OTM in both strategies. In this region, rho is relatively closer to zero. For buy-writes and put-writes that are written the same amount out-of-the-money (e.g. 5% above for calls and 5% below for puts), the magnitude of the rho for the short put is generally greater than the magnitude of the rho for the short call.
For many of the buy-write ETFs, the options are written slightly out of the money. This leads to increased rate sensitivity compared to a put-write ETF like HVPW that writes the puts 15% out-of-the-money. Overall, a buy-write ETF will have some interest rate sensitivity in the options it holds as short positions, but as it rolls over its positions, it will benefit from increased option premiums since the calls it sells are now worth more.
For put-write strategies, the puts it holds would increase in value as rates rise, but since it holds them to expiry, this is not a big issue. For a fund like HVPW, when it rolls over its portfolio at higher interest rates, the options it sells would generate lower premiums, but this could be at least partially offset by interest earned on the cash it holds to secure the puts. Overall, how these two factors play out in a put-write ETF is a toss-up; the overpricing of the options (i.e. shape of the volatility curve) and the frequency of highly correlated market drawdowns are likely to have larger effects on the yield and price going forward.
While put-write and buy-write ETFs come with their own unique set of risks, their interest rate risk is relatively small. This is great news as we head into an uncertain rate environment. Rates are extremely low and are poised to rise as the FED continues to taper its quantitative easing, but exactly when and how this will happen is unknown.
Both buy-writes and put-writes are more dependent on the movements of their underlying stocks than on interest rate shifts. If a rising rate environment comes hand-in-hand with an improving economy, these strategies may best be used as income and overall portfolio diversifiers. They may sacrifice some of the upside but will likely offset a portion of the downside with the yield to deliver an equity driven exposure with lower correlation and volatility than core equity holdings.