Run your own fixed income annuity

Fixed Income Annuity - 19th Century Book - 20200504

Sometimes you just want to make the guaranteed risk return with the possibility of some upside, but with a guaranteed return of principal. This is typically where fixed annuities come in, however they can be expensive with up front load or annual management fees. Fixed annuities can also be structured in an opaque way where it is not clear exactly what investments the product has bought and how they are managed (e.g. trade turnover etc) – in short they are not very transparent.

Please note: A fixed income annuity is a very complex contract between you and the insurance company. Therefore it is not perfectly compared with the actual investments described in this blog – but this is a starting point to see if the flexibility of doing it yourself might give you some more transparency.

So … is it even possible to run your own fixed income annuity style investment ? Preferably with minimal management, without all the fees and long lock up periods. This blog post is a look back at an annuity style strategy that has been executed for the last few months.

Lets assume we’d like to do this with a lump sum principal of $100,000 USD. It is pretty easy to create medium term US treasury portfolio which is close to the risk free return – lets assume we can construct an equal weighted multi year duration portfolio of treasuries up to 5 years out. Technically there is some duration risk on the longer dated treasuries, but it’s decent proxy for a stable risk free return portfolio. A few months ago in Feb 2019 this had a blended rate of approximately 2.5% – yielding about $2500 a year in interest. See this table for the basic treasury portfolio construction:

Price Date
US Treasury Duration
US Treasury Yield (annualised)
Principal Amount
Yield Amount (annualised)
TOTALS$100,000$2,528
13th-Feb-20196 months2.51$20,000$502
13th-Feb-20191 year2.55$20,000$510
13th-Feb-20192 years2.53$20,000$506
13th-Feb-20193 years2.52$20,000$504
13th-Feb-20195 years2.53$20,000$506
See prices from US Government Treasury website

Managing interest rate risk

However over the next few years, rates might go up or they could be cut. Ideally when each treasury expires we’d like to be able to roll into a new treasury bond with a similar or higher interest rate. However by the time that happens the interest rate market could have moved. So how to manage that interest rate risk without risking any principal?

Since Bond prices will increase when interest rates go down some hedge needs to be provided against falling rates. More simply – something that makes money when rates go down.

In March 2019 we started adding to the above treasury portfolio, by using limited risk bullish short put spread in TLT options. In theory TLT should go up if FED was to cut interest rates and go down if rates rise. TLT contains bonds that have an approximate 17.8 year bond duration, so it is not a perfect proxy for own mini fixed income portfolio that has an average duration of about 2.5 years – however it should be correlated at least. Plus TLT does have very liquid options market that is a couple of pennies wide and can often get filled at mid price, so we can be confident of getting liquid fills on the option trades.

This TLT “short interest rates” trade can be done fairly simply using an ATM bullish put spread, with a slight time decay in your favour on trade entry. There appears to nearly always be a small amount of extrinsic value in an ATM put spread appears to be consistently available, because TLT itself has an actual yield – so you would expect to get paid something for holding it for 90 days even if (all other things being equal) the price never moved. For example if the market is $125, you can sell 5 contracts of $126 put and buy 5 contracts $124 put 90 days out for a credit of $1.05. That would give approximately $0.05 of extrinsic value with $1.00 of instrinic value. If TLT rallies over $126 by expiration can make $550 for that quarter, if it closes below $124 lose $450 for that quarter. Obviously if rolling the put options is considered this becomes way more complex, but waiting to close until near expiration is the simplest case.

If you want to replicate a true fixed annuity with no risk to principal, you’d have to be careful size each trade to not risk too much on each TLT put spread. Lets assume we will do one put spread per quarter, and risk $500 per quarter per spread – that would mean in theory we could lose $2000 ($500 x 4 quarters) on the spreads. However since we gain $2500 in treasury interest, so we’d still be $500 ahead for the year. Not great obviously, but that is the theoretical worse case scenario and if we want guarantee to maintain principal then we have to be cautious with the risk. This is an annuity strategy where aim is to take some market risk but only with money gained from interest payments, never from the principal.
If you wanted to take equity risk as well, this could be applied using SPY option spreads, but recognize that is obviously not as tightly correlated to US treasury rates as TLT.
If you did lose money on the TLT spread, that would be an advantage to you when you come to re-invest any expiring fixed income, because the treasury rates would be higher.

To clarify the idea here are a couple of actual trades to show the principal. One is a simple bullish put spread. The second one was a combination of bullish put spread with a bearish short call spread sold against it.

TLT bullish put spread

This trade was entered into in March 2019, then exited closer to May 2019 expiration on 1st May. There was a $369 profit as TLT had traded up slightly. This took approximately 50% of available profit.

 
Trade Date
Category
Trans Type
Description
Symbol
Quantity
Price
Amount
21-March-2019
Hedging
Buy to Open Long Put
Put TLT 121.00  EXP 17-May-2019
TLT190517P121
5.0
0.88
$434.64

21-March-2019
Hedging
Sell to Open Short Put
Put TLT 124.00  EXP 17-May-2019
TLT190517P124
-5.0
2.36
-$1,182.24

TOTAL
-$ 747.60

 

TLT bullish put spread with bearish call spread

A couple of days later on 3rd May a similar bullish put spread trade was opened June options, but this had an overwrite with a call spread to give the trade some option premium to sell. Normally trades would be rolled the same day, but there was a couple days in between trades because the earlier trade was trigger by a limit order (and didn't notice position was exited).

 
Trade Date
Category
Trans Type
Description
Symbol
Quantity
Price
Amount
01-May-2019
Hedging
Buy to Open Long Put
Put TLT 121 EXP 21-Jun-2019
TLT190621P121
4.0
0.49
$194.24

01-May-2019
Hedging
Sell to Open Short Put
Put TLT 125 EXP 21-Jun-2019
TLT190621P125
-4.0
2.24
-$896.79

01-May-2019
Hedging
Sell to Open Short Call
Call TLT 126 EXP 21-Jun-2019
TLT190621C126
-4.0
0.60
-$241.75

01-May-2019
Hedging
Buy to Open Long Call
Call TLT 127 EXP 21-Jun-2019
TLT190621C127
4.0
0.45
$178.24

TOTAL
-$ 766.06

 

This trade was entered into on 1st May 2019, then exited closer to June 2019 expiration on 3rd June. This holding period fits with the 30 day rule. Unfortunately selling the call spread did not help the position here as it lost $345.97. If TLT had been flat to slightly down then the call spread would have made money. Fortunately the bullish short put spread made most of the profit ($694.02) because TLT had traded up significantly higher. Exiting the bullish short put spread and bearish short call spread together as a combination though made a total profit of $348 ($694.02 - $345.97).

For reference here is an interactive price chart for TLT that can be used to see the prices from Feb 2019 to June 2019. On chart use minus (-) zoom control to zoom out, then click, hold and move mouse to the right to navigate back to 2019.

Fixed Income Annuity - Summary

This blog post showed how it is possible to take small profits out of TLT to increase yield, but with limited risk if TLT goes down. In this real life example TLT went up, so the May and June spread trades added a few hundred dollars in yield. However if TLT did go down that would be an advantage to the main US treasury principal because new bonds could be bought with higher yield to expiration. This might need some tweaking to make into a better results, but it demonstrates the idea. There is approximately 30mins monthly effort required to analysis, enter, monitor and roll the TLT spreads. Running your own "annuity" product is potentially a lot cheaper than an traditional annuity that charges upfront load fees and annual fees.

Brexit trading update – the aftermath

This will be the final general Brexit trading update – after this will resume general separate trade updates, but just wanted to get down all the trading moves made since last Friday and this week.

In summary it is a political mess in UK following Brexit. Prime minister resigned, opposition leader under threat for not campaigning strong enough for stay vote and Scotland threatening to veto the decision. On top of that Europeans telling UK to get on with a timetable for leaving. Not to mention the final hammerblow of England losing to Iceland in Euro 2016 (Brexit likely not as traumatic as the football exit for some people…).

However .. on to the trade update. If your trading account is still alive after the last few days after brexit… Congratulations! We were NOT expecting a leave vote to win, however we have to adjust our positions. Fortunately the implied volatility is still sky high on currencies and equities, so adjusting by selling premium is not that hard.

We are now now bearish USDGBP for the next few months. Not betting on immediate rebound. Any rallies are to be sold. There will probably be huge counter trend rallies based on discussions or actual BOE currency intervention, however those should be taken as a opportunity to short at higher levels. Limited risk reward with all bearish trades (eg call spreads or put / put spreads). Also medium term bearish on UK equities, but fallout from US equities will almost certainly be less for US versus UK. Not convinced that US market will react dramatically to Brexit over next few months (isn’t not likely on it’s own to cause a bear market). Would like to do short premium trades that take advantage of the high implied volatility env. Once again… if your trading account is still alive after the last few days of trading brexit your risk management rules are working.

Our portfolio had a relatively large number of short premium strategies going into the vote. These had to have minor some adjustments after the vote, which we did relatively quickly in most cases. There were also some strategic portfolio hedges to protect existing long positions that were quickly added on the Friday after Brexit (fortunately at pretty decent prices). Here are the trades we actually did …

Brexit trading update – Friday

Hedged our entire GBP cash position with a combination futures trade. This was hedged at 1.385 into the bounce on Friday morning at much better prices than overnight.
Brexit trading update - 6B Jun 2016 Bear Call Spread and Put - chart trade entry - 20160624

The combination /6B futures trade was needed to have full downside protection – without over paying TOO much for volatility (although some volatility premium needed to be sacrificed to hedge against total free fall).
Brexit trading update - 6B Jun 2016 Bear Call Spread and Put - trade entry - 20160624

Added these two bearish trades with a SPY put butterfly in the morning and IWM put butterfly near the close. These have no downside risk and were added when vol was high so could get strikes wide apart.

SPY put butterfly
Brexit trading update - SPY Jun 2016 Put Butterfly trade entry - 20160624

IWM put butterfly
Brexit trading update - IWM Jun 2016 Put Butterfly trade entry - 20160624

Hedged our entire Canadian dollar real estate position with a combination futures trade. This might be an over reaction to Brexit because the Canada/USA economic trading relationship is not likely to be directly affected. However if the market goes into “risk on” mode and oil prices decline then the USDCAD rate would suffer.
Brexit trading update - 6C Jun 2016 Bear Call Spread and Put - trade entry - 20160624

Brexit trading update – Monday

Shorted ATM volatility by adding a short call spread against the tested side of our existing FXB iron condor placed prior to Brexit. Also locked in a guaranteed profit on the short call spread by buying a very cheap call vertical. This is our way of rolling down within the confines of the 30 day rule – without this rule you’d just close out the call spread, and re-sell it at the lower strike. Trade has only $203 risk now:
Brexit trading update - FXB Jun 2016 Iron Condor trade adjustment - 20160627

Sold a QQQ iron condor similar to Tasty Trade’s good trade / bad trade – not our idea, but will take it.
Brexit trading update - QQQ Jun 2016 Iron Condor trade trade entry - 20160627

Short TLT bond call spread – don’t really like this trade from risk/reward (doesnt make much even if right) but just trying to sell bond premium in high vol with limited risk (and start a very small short position at recent all time highs).
Brexit trading update - TLT Jun 2016 Bear Call Spread trade entry - 20160627

Brexit trading update – Tuesday

Didn’t do much because implied volatility had contracted quite a bit, so there wasn’t that much premium to sell. Still not happy with QQQ and TLT positions – slight rise in market or bonds is going to hurt these positions.

Brexit trading update – Wednesday

Didn’t do much, big market rally again. Implied volatility reduced again. Sitting on hands for now. GBP rally somewhat muted given general “risk off” market rally.

Brexit trading update – Thursday

Portfolio is now getting too short for comfort – we have also iron condor established early in June in XME, EWZ that are rallying hard through the short call strike today. Adjusted the QQQ iron condor established on Monday to get some more long deltas in the portfolio.
Brexit trading update - QQQ Jun 2016 Iron Condor trade adjustment - 20160630

Brexit trading update – conclusion

Handled the actual event pretty well, but was caught off guard a bit because do not expect this massive bounce. Lost about 1% of the account in the bounce because pushing too hard on the short side (but that was arguably justifed given the initial market reaction). Ironic though because through out actual brexit in about Monday – the account was flat to slightly up. So navigated it pretty well initially, but frustrated to be losing money in last couple of days when did so relatively well on the initial reaction. Live and learn – and definitely not a write off experience.