Box Spreads as a Fixed Income Replacement

Box spreads provide the ability to transform fixed-income returns (typically ordinary income tax treatment) into capital gains. This is particularly valuable when there are realized tax losses elsewhere in the portfolio to offset that income.

Box spreads, an exchange-listed index options strategy, offer a unique method to achieve fixed income exposure taxed at the 60% long-term and 40% short-term capital gains rate as opposed to 100% ordinary income in the case of bond interest. This can be particularly favorable when you have tax losses that can offset the gains generated from the box spreads.

Constructing a Box Spread

While this may seem technical, a box spread strategy can be viewed as combining a synthetic long and a synthetic short options combination. The synthetic long has a similar payoff to owning a stock, which consists of buying a call and selling a put with the same strike and expiration. The synthetic short has a similar payoff to shorting a stock, which consists of buying a put and selling a call at the same strike and expiration. Combined, the long and short synthetics remove the market exposure, leaving only exposure to interest rates.

If the box spread is a debit spread, meaning that you outlay cash, it is roughly equivalent to buying a zero-coupon bond maturing at the time of options expiration since the synthetic long and synthetic short cancel out exposure to the index. If the box spread is a credit spread, meaning you receive cash, this is effectively a loan that matures at the time of options expiration. For this article, we will focus on debit box spreads with payouts similar to zero-coupon bonds.

The advantages of European-style index options such as those on SPX (S&P 500) and RUT (Russell) include:

• European-style options do not have the early exercise risk of American-style options on ETFs and stocks
• Index options are cash-settled, while options on ETFs and stocks can result in the delivery of long or short positions.
• Potentially benefit from marked-to-market 60% long-term and 40% short-term capital gains treatment, which can be favorable from a tax perspective and simplifies reporting.

Example

• Treasury Bill and Box Spread Filled at the Same Yield
• Data as of Thursday, October 20th, 2022, at 3:49 PM:
• Purchase $100,000 of US Treasury Bills Maturing January 19th, 2023 
  • 3.97% Yield-to-Maturity, assuming purchased at the asking price of 99.03
    • Total Outlay: $99,030
    • Yield Calculation: [(100-99.03)/99.03] / [90 Days to Expiration / 365 Days in a year) = 3.97% Yield-to-Maturity
    • Value at Maturity (90 days later) = $100,000

• Purchase 1 Russell 2000 Index Options (RUT) Box Spread
  • 3.97% Yield-to-Maturity, assuming purchased at a price of 990.30
    • Components:
      • Buy 1 RUT Jan19’23 1000 Call
      • Sell 1 RUT Jan19’23 1000 Put
      • Buy 1 RUT Jan19’23 2000 Put
      • Sell 1 RUT Jan19’23 2000 Call
    • Total Outlay: $99,030 
      • Assumption: Limit Order filled at a price of 990.30 (100 multiplier on index options), which is a yield equal to the ask price of Treasury Bill filled at 99.03 (ignoring transaction costs) 
    • Yield Calculation: [(1000-990.30)/990.30] / [90 Days to Expiration / 365 Days in a year) = 3.97% Yield-to-Maturity
    • Value at Maturity (90 Days Later): $100,000

Note: Anecdotally, a well-executed box spread trades fill at a yield slightly higher than a zero-coupon US Treasury maturing at the same time as the Box Spreads options expire, but we are assuming that we obtain the same yield for this article. Limit orders are particularly important given wider spreads between the bid/ask on box spreads versus equities and US treasuries.

Tax Considerations

The value of converting ordinary income treatment to capital gains treatment can be relatively high when a taxpayer has harvested capital losses that can be used to offset gains. The 60% Long-Term and 40% Short-Term treatment of Section 1256 Contracts (which include but is not limited to index options and futures contracts) can allow for greatly diminished but still appealing tax characteristics versus ordinary income for Federal taxes even without offsetting losses in no or low tax states. On the other hand, as you’ll see in the example below, when comparing US Treasury Bond interest not subject to state tax to box spreads, it may not make sense from a tax perspective when offsetting capital losses are unavailable.

Multi-leg options contracts can trigger complex and sometimes undesirable tax treatment related to tax straddles and mixed straddle rules. For this reason, it may be best to avoid implementing box spreads in equity indices that are “substantially similar” (the standard for which constructive sale and tax straddles are triggered) to other positions in the portfolio. The Tax Code defines substantially similar as 70% overlap on a cap-weighted basis.

Examples:

• ETFs based on the Russell 1000 Index and the S&P 500 large-cap indices have approximately 90% cap-weighted overlap and would likely be considered substantially similar.
• ETFs based on the Russell 2000 Index and the S&P 600 small-cap indices have approximately 36% cap-weighted overlap and may not be considered substantially similar.

After-Tax Yield Comparison

Assumptions for All Examples

• $10,000 of Treasury Income or Box Spread Income
• 37% Federal Bracket
• 3.8% Net Investment Income Tax
• New York State: 6.85%
• New York City: 3.876%

As shown in the summarized chart below, box spreads are most appealing when the income is offset by realized capital losses.

¹ Treasury bills are not subject to state or local taxes

Risks

• Box spreads are generally considered a strategy for investment professionals due to the complexity involved in implementation.
• Brokers typically require margin and high-level options approval to implement these strategies. Trading and execution errors could result in significant losses.
• The examples provided do not include the impact of fees, commissions, and execution at undesirable prices.
• Exiting the position before maturity could result in losses due to execution, liquidity, and an increase in interest rates, among other factors.           
• Investors should consult with their tax advisors to determine how the profit and loss on any options strategy will be taxed. The tax laws and regulations that apply may be complex, change from time to time, and be subject to interpretation.