Box spreads = financial innovation?
For avoidance of doubt, my general position is that financial innovation is often terrible for customers. “Innovation” from the perspective of many financial companies merely involves coming up with more creative ways to separate people from their money. Financial innovations too often lead to more complexity. And if I’ve learned anything in my career, it’s that complexity is the mortal enemy of everyday investors. The financial industry simply isn’t very trustworthy in the eyes of the general public.
However, every once in a while, a financial innovation can offer value to regular folks like you and me. A couple of big examples include low-cost, passive index funds and the exchange-traded fund (ETF). Both of these products have improved conditions for investors all over the world and saved trillions of dollars in fees and taxes (not an exaggeration). If you don’t believe me, just ask any investor over 70 what it was like trading mutual funds back in the 1970’s and 80’s.
Are there any recent examples of good financial innovation? In response, I present the box spread as a potential candidate! I admit that the jury is still out on whether box spreads will be helpful or useful to regular, everyday investors, but there are some positive signs for certain subsets of investors (more on that later), so I think it’s worth taking a closer look.
I should also be more precise. Box spreads themselves have been around for a long time (decades). The “innovation” in this case comes in the form of products which allow for more democratized access to the use of box spreads. The two main products we’ll focus on include the box spread lending service from SytheticFI and the Alpha Architect 1-3 month Box ETF (BOXX).
What the heck is a box spread anyway?
In a nutshell, a box spread is a strategy using a combination of four call/put options in a precise way such that you can either lend or borrow at attractive rates and/or with attractive tax treatment. Confused yet? You’re not alone. Just remember that a box spread simply uses options to synthesize a debt instrument.
I’m not going to go into the mechanics on how box spreads are constructed.1 The important thing to remember is that you can buy (aka “go long”) a box spread to lend money. Or you can sell (aka “short”) a box spread to borrow money. Using a box spread, it’s often possible to lend or borrow substantial amounts of money at rates around 0.20-0.30% above US Treasury yields.
Use caution if you plan to do it yourself
One note of caution is that, for the average investor, trading box spreads is not advisable. As I mentioned before, a box spread involves trading four options in a specific way. And while it’s true that most brokers offer tools to help trade box spreads, if you mess up trading a box spread, it could blow up in your face and leave you with an expensive mess to clean up. For that reason alone, it’s a good idea to be cautious around trading a box spread yourself.
If you work with a large financial advisory firm, it’s possible that they have an in-house trading team that can handle trade execution. But smaller firms (including myself) will likely hesitate to execute box spread trades unless they specialize in doing so.
Mortgage substitute?
Thankfully, it’s possible to outsource the trading (for a fee of course). One company, SyntheticFI, can help execute the trades in exchange for what amounts to an additional spread on the effective borrowing rate.
As an example of how a box spread can help with lending, let’s pretend that you want to buy a house for $500,000. Historically, most people would put 20% down ($100,000) and get a loan from the bank for the remaining $400,000 using a standard conforming mortgage (e.g. 5/1 ARM, 15 or 30 year fixed, etc.). Right now, the current 5 year box spread rate is about 3.8%. To compare apples-to-apples, we’ll benchmark that against the current 5/1 ARM rate, which is roughly 5.5%. Using a box spread instead of a 5/1 ARM could offer 1.7%/year of interest savings at current rates. This translates to about $6,800/year on a $400,000 loan, or about $34,000 over 5 years.2 That’s not too bad!
But wait, there’s more! Some additional benefits of using box spreads include:
- No down payment.
- No monthly payment, just a balloon payment at maturity.
- No underwriting, which means fast access to funds.
- No mortgage-related closing costs.
- No escrow requirements.
- Capital loss treatment for the effective interest costs, which can offset other capital gains or ordinary income on your tax return.
- No deduction limit tied to the size of the loan (unlike with the $750,000 mortgage ceiling).
- Continued deferral of embedded capital gains on your taxable brokerage assets.
In addition to mortgages, box spread loans also offer a viable alternative to a HELOC, securities-based line of credit, margin loan, or personal loan.
Sounds pretty good right?
What’s the catch?
Unfortunately, there are some caveats. In addition to the trade execution difficulty, other limitations and downsides to using a box spread include:
#1 – You need a large taxable brokerage account
First, you’ll need a sizeable pool of assets in a taxable brokerage account (box spreads aren’t allowed in IRAs). Much like a portfolio line of credit or margin loan, the assets in your taxable brokerage account act as collateral for the box spread loan. Most brokers will allow you to borrow up to 50% of the value of your taxable brokerage assets, but sometimes you can borrow more depending on the make up of the underlying assets. But generally speaking, if you have a $1,000,000 brokerage account, the most you can borrow is $500,000. Using a box spread loan will subject you to potential margin calls by your broker. If you borrow too much or the markets don’t cooperate, you could be forced to come up with cash in a hurry.
The larger your taxable brokerage account, the more ability you’ll have to use the box spread as a funding mechanism. It’s still possible to use box spreads for smaller loans (say $10,000), but most of the benefit is only available to those investors with large taxable brokerage accounts.
Some of you may be wondering why box spread lending is subject to collateral requirements. After all, you aren’t borrowing from your brokerage firm directly. So can’t you just execute the trades, withdraw the cash, then re-deposit the cash just prior maturity? Well, imagine a guy named Trusty McTrusterton opened a brokerage account with zero dollars in it. Trusty then logs in to his brokerage platform, and sells a box spread worth $100 million. Now Trusty has two things in his account:
- Just under $100 million of cash
- A $100 million liability (in the form of four option positions)
Do you think it would be a good idea for Trusty’s brokerage firm to allow him to withdraw $100 million with a pinky promise to repay it when the options expire? No, it would not be a good idea. At all. Brokerage firms wisely force anyone selling a box spread to collateralize the liability with the other securities in the account.
#2 – The loan term only extends to 5 years
Another limitation of the box spread is the time horizon. Due to option mechanics, the most common option product used for box spread lending is the S&P 500 Equity Index Options on the CBOE. Currently, the CBOE only offers contracts out to 60 months. So the longest term you can borrow for is 5 years. If you need a 30-year loan, you’ll need to look for a regular mortgage product.
#3 – It’s hard to pay off early or make changes
Box spreads are also not easy to pay off early or adjust once executed. To do so, you need to buy back the strategy at then prevailing prices. For instance, if you take out a 5 year box spread, but decide later that you don’t need it, then you could incur a cost to unwind the position, especially if interest rates have shifted in the time you’ve had the position on. Generally, it’s best to hold a box spread loan until the options expire.
If you plan to borrow money on a revolving basis, that is borrow some money for a bit, pay it off, borrow some more, pay it off, etc. then it’s likely better to use a product like a HELOC or securities-based line of credit. It’s possible to use box spreads to facilitate revolver-type borrowing, but it would require more administrative hassle and trade execution risk.
#4 – The tax reporting gets more complicated
The effective interest charges on a box spread loan are treated as capital losses on your tax return. 60% is a long-term loss and 40% is a short-term loss. But you’ll need to make sure and let your CPA know about what you’re up to so they can correctly report everything on your return. I admit that this is a minor drawback as you’d likely have to do a similar level of admin work for loan interest expenses and your brokerage firm will likely do most of the heavy lifting by reporting the amounts you need on your 1099.
The risks are manageable
With all of the downsides I listed, I still think the risks of box spread loans are manageable. For example, if you are extra careful about the trading, you’ll limit issues around trade execution. Or you can use a HELOC as a backstop funding source in case markets crash and you receive a margin call. Another strategy is to use a series of smaller box spreads instead of one large one to allow for flexibility.
The other side of the coin
Most of this post has focused on using box spreads a source of cash. But you can also lend money to others using a box spread. After all, if so many people are borrowing money using box spreads, somebody must be lending to them right?
The main product in this space is the Alpha Architect 1-3 month Box ETF (BOXX). BOXX is a short-term fixed income fund that offers an alternative to investing in something like treasury bills.
There are two main benefits to using BOXX.
#1 – A slightly better yield than treasuries
With BOXX, you can lend money at rates 0.20-0.30% over treasuries. However, this is offset by the fund’s management fee of about 0.20%. So basically a wash.
#2 – A unique tax treatment
The second benefit is a unique (and disputed) tax treatment. Generally, if you purchase a treasury bill, or almost any fixed income investment, the interest payments that you receive are taxed as ordinary income. However, the creators of BOXX believe that they have designed the fund in such a way that the interest generated by the fund will be taxed as a capital gain, which generally has lower applicable tax rates.
The idea is, if you buy BOXX and hold it for at least a year, then your interest income could be taxed at a lower rate. The tax benefit could be substantial depending on your personal tax situation. For example, if you are a high-earner in the 37% tax bracket, then converting interest income to a capital gain will cut the tax rate down from 37% to between 15% or 20% (ignoring NIIT because it would apply either way). For ultra-high net worth folks, the tax savings could be substantial. In a nutshell, BOXX’s main value proposition is an enhanced after-tax yield on a short-term fixed income investment.
However, experts disagree about whether BOXX’s tax strategy is actually viable under the tax code. The IRS could decide down the road that BOXX is subject to the same rules and tax treatment as any other fixed income fund. If that came to pass, it could be a mess for investors (although I imagine the IRS could show mercy at the investor-level). And after that point, there wouldn’t be much incentive to invest in BOXX going forward. But as of right now, my understanding is that BOXX is still supporting the more advantageous tax treatment. And most investors are reporting their income in line with BOXX’s view. So we’ll have to wait and see.
The verdict = still unknown
These products are very exciting, but my sense is that it’s still a mixed bag for investors. Some people will see tremendous value from these products, but most won’t have any reason to use them.
I don’t see much risk in BOXX’s tax strategy at the moment. But there isn’t much upside either unless you find yourself in a very high tax bracket and have a lot of capital that you need to park in a short-term investment.
And box spread loans could definitely offer value to certain people. A box spread loan could be a good solution anytime you need to smooth out near-term cash flow issues. Essentially, anywhere you might need a bridge loan. For instance, if you plan to relocate, you could use a box spread to fund the purchase of the new house, and then pay everything off when you sell your old home in a month or two. This would avoid the hassle and cost of getting a mortgage for only a short period of time.
You could also use a box spread loan to simply reduce your borrowing costs. If you have a high interest mortgage, perhaps it makes sense to borrow using a box spread and use the proceeds to pay down the mortgage balance.
There are some good use cases for these products. But as I mentioned before, sometimes keeping things simple is the best way to approach a problem. On the other hand, Albert Einstein said, “Everything should be made as simple as possible, but not simpler.” So maybe a little complexity in the hope of reducing borrowing costs or enhancing the after-tax yield on your short-term bond fund makes sense.
Until next time.
1 If you want more information about the mechanics of box spreads, check out this and this.
2 Actually, the savings would be a bit less do to the amortization of the 5/1 balance.
