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The worsening rout in U.S. Treasury bonds is unfolding alongside a sharp rise in box spreads, an options strategy increasingly used as an alternative to conventional fixed income. The trade has moved from an institutional niche toward wider use by funds, advisors and individual investors.

A box spread combines four options at two strike prices, pairing one bullish call spread with one bearish put spread. The trades are conducted mostly on the S&P 500 Index and create a market neutral position.

At execution, the position’s price becomes cash received by the seller, who acts as the borrower. At expiration, its fixed value becomes the total amount received by the buyer, who acts as the lender, with the difference representing interest paid to that lender.

That structure delivers about as close to risk free income as the derivatives market offers. Because the trade is an equity derivative product, it falls under the lower tax category of capital gains rather than interest income.

The value of open box trade loans on S&P 500 options reached an all time high of $146 billion last Friday, according to Cboe Global Markets data compiled for CNBC. That figure highlights how rapidly the once obscure strategy has expanded.

Average daily notional value traded exceeded $2.3 billion last month, marking a 26% increase from a year earlier. Retail traders accounted for $54 million of the daily total, showing that participation now stretches beyond major institutions.

S&P 500 box spreads using contracts that expire in three months currently provide income exceeding 4.4%. That compares with less than 4% on three month Treasuries and an overnight SOFR rate of about 3.9%.

“We’ve seen an uptick in use by ETF sponsors, wealth advisors, and even some larger retail accounts who have found the effective interest rates beat their alternatives on both the lending and borrowing side,” Henry Schwartz, VP of Derivatives Market Intelligence, said in an email.

Box spreads were once considered clever but complicated transactions largely reserved for major banks and sophisticated institutional clients. They have since entered the mainstream as exchange traded funds package the strategy into low cost vehicles and investors become more comfortable with options based approaches.

At least three ETFs tracking the trade have about $20 billion in total assets under management. The largest is Alpha Architect’s $15 billion 1-3 Month Box ETF, which trades under the ticker BOXX.

Those amounts remain small compared with the $30 trillion U.S. Treasury market. Even so, the growth reflects increasing interest among financial advisors and individual investors seeking alternatives to traditional fixed income assets and looking for more tax conscious strategies.

The expansion also arguably adds pressure on the Federal Reserve to push interest rates higher so bonds can compete with income available elsewhere. Box spreads currently offer better effective rates than some alternatives on both the borrowing and lending sides, according to Schwartz.

Yet the strategy’s growing scale is attracting attention from Washington. In July, the Treasury Department said it was examining investment strategies aimed at avoiding U.S. tax rules, with box spread funds and other tax minimizing approaches used by advisors among those facing scrutiny, according to Reuters.

No new rules governing box spreads have been issued. Still, some bond market observers question whether the trade’s popularity could divert capital that otherwise might have entered the bond market.

“Box spreads have been around for ever but volume is picking up for all kinds of options so liquidity is no longer restrictive,” said one financial advisor who asked not to be identified until the government clarifies its position on box ETFs.

“You can use different iterations of derivatives which historically would have been more likely to go to fixed income or cash.” With box spread volumes rising and Treasury yields trailing the strategy’s current income, the competition for investor capital is becoming harder for the bond market to ignore.

DISCLAIMER: GoldInvestors.news is not a registered investment, legal or tax advisor or broker/dealer. All investment/financial opinions expressed by GoldInvestors.news are from the personal research and experience of the owner of the site and are intended as educational material. Although best efforts are made to ensure that all information is accurate and up to date, occasionally unintended errors and misprints may occur.