Generating interest income on idle cash balances kept in retail brokers - a theory

[Daal]

Lets say a trader has a couple of brokers that don't pay any interest on idle cash balances. Say $250K on each. I believe I figured out a way to generate interest income on those balances with very low risk (finance theory would call it no risk) while NOT hurting your margins and buying power. That latter point is very important, its the most important thing because if it wasn't all you had to do was to buy short-term bond ETFs and that would be it. Doing that, however, will cut down your margin and buying power considerably

There is an alternative though. All you have to do is to have money on the side (lets say at your bank and/or Treasury Direct) and buy 30 year UST bonds!

Because you have a lot of cash with 0 duration and 0 risk, if you own bonds with a lot of duration with other funds that you have, your AVERAGE duration will still be quite resonable. Matter of fact, it might be almost mathematically equivalent as if you owned 2-3y USTs in the ENTIRE portfolio.

Now, I know what some people will say "well, you didn't buy anything with the brokerage cash, how are you generating yield on that". The cash (with zero duration) is what ENABLES you to "chase" duration with the other funds while STILL keeping your average duration across your entire networth quite low. The cash is being 'used' in the sense that it allows you to take the extra 'risk' with the other money.

How much yield can you generate? It depends on your personal situation, which brokers do you have and how much money do you have set aside outside your brokers. More aggressive traders that keep almost 100% of their funds in their broker could be out of luck. That is, unless they use IB or another broker that lets you buy bonds.

Someone might say "but isn't it risky to lend to the US government for 30 years", it could be but if the government is going to default, that idle cash that you own will become international confetti anyway (inflation will decimate those balances and it will plunge against all currencies), with bonds at least you get PAID to take that risk. Still, if you are not comfortable going out 30 years, you can buy the 10 or 15 year bonds. It will require more bond buying to generate the same yield but if you need that to sleep at night then so be it. I'm still not sure that you will be better off with the cash. Not in the US anyway, the most likely scenario is that they will inflate their way out. With bonds at least you get 3% per year all the way to the armageddon day, which might or might not come. Still, if you are worried you can buy the 10 year.

Now, lets go back to that situation from the trader above. If the trader put $200K that he had set aside in a bank or in a broker that allows you to buy UST bonds, in 30 year bonds. He would get paid roughly $6K a year. His entire networth is $700K, that is an yield of 0.85%. Which is the equivalent of being long 3 year UST treasuries across the entire portfolio (going off the top of my head). Now, its not the same as being long the 3 year treasuries. Things can get a bit more complicated because of spreads among different bonds and stuff like that but its quite similar.
This an extra $6K a year that would not otherwise be there. It can help cover software fees, data fees, news fees, etc. Its free money so why not take it. Is there is risk involved? The risk is that interest rates rise more than what is priced in the curve. You missed out on the chance of invest at even HIGHER interest rates than 3% but still, without that strategy, you were getting 0% anyway, so you are better off.

And as I said, you can mitigate some risk by using the 10 or 15y UST bond if you are THAT worried about rising rates

Comments, questions, criticisms are welcome

 

[Daal]

There might be another benefit. If the bonds decline in value, there COULD be a tax advantage by selling them at year end and creating tax losses for overall better tax efficiency. Then you could rebuy similar bonds 31 days later. Now, I'm not US tax expert so I have no idea of what I'm saying is any true but its something to explore

One could also be more fancy and buy US bond indexes instead of the 10-15-30y bond. Those bonds indexes will invest in higher yield stuff like mortages (guaranteed by FNMA FMCC), corporate bonds, etc. So it will yield more per year of duration. You might even get that 3% with same duration of the 15y UST, you just got to explore around. If you are worried about the 'risk' of the fund, just remember that you got the vast majority on 0 duration and 0 risk. Taking a bit more risk in the excess cash (or the cash at IB) is STILL a very conservative allocation

 

[Daal]

For instance, the benchmark (Barclays Lehman AGG index), right now has a avg duration of 5 years and avg maturity of 7 years. Yet it yields 2.4%
https://www.ishares.com/us/products/239458/ishares-core-total-us-bond-market-etf

This solution doesn't work for me because since I'm a non US trader, I get taxed 30% on dividend distributions. I get taxed 0% on bond interest. But for US based traders, it works
Over 65% of the index is on low risk stuff like treasuries and mortages

 

[Daal]

Now, this works if the curve is steep like right now. But what if the curve is flat? In that case, putting 5-10% of the capital in higher risk bonds (diversified set of corporate bonds) and keeping the rest in cash is SIMILAR to having all the money in low risk bonds. The idea is that a little bit of medium risk with a lot on no risk is similar to everything on low risk. Its not a perfect similarity but over the long-term its likely to work

 

[TZT]

I like your idea. If I understand you correctly: instead of putting all the cash into low risk bond, you can just put some of that into 30yr US-T? I have been doing this in my Interactive Brokers account, which let you buy 30 US-T from dealers and hold in your main account, so no need for even Treasury Direct.

 

[Daal]

I've realized that there is a better way to do this without taking on the duration risk of the 30 or 10y. You can use futures and buy the 5y UST bond future. So, if the trader has $100,000 in an account that does not pay interest, he can go long the 5y bond future and 'effectively' earn 1.4% (or whatever the yield is right now) minus the 1-2m libor (thats the premium futures buyers pay to be long), minus commissions of rolling over the contract. Should come out at 1% a year. If you got $500K of cash in brokers thats $5K a year in extremely low risk cash that you earn. Sometimes, that future will lose money in a given year but that is offset by the higher interest that you will be able to earn the next year (and hence, the lower chance that you will have a losing year, that year). Most of the time, though, you will make some, likely the yield of the 5y bonds. Its more margin and cash efficient to use the future

 

[Daal]

Its important to note that this only applies to solid winning traders. If the trader is a losing or an uncertain winner, than the cash is not safe and hence you don't know how big of a bond future position to buy

 

[Maverick74]

OK, this has been done since the 1970's since treasuries became collateral. Let me simply this. You can buy ANY bill, note or bond in cash and use 95% of that value for trading as collateral. You earn whatever the coupon is on that bill, note or bond. This has been around forever and anyone who has traded futures knows this because FCM's never paid interest on balances even when short term interest rates were at 15%!!!!!!!!!!. Perhaps you were not aware of this before and I suspect most people are not. This was very apparent in the 1980's because most commodity traders had who opportunity costs leaving cash balances at FCM's.

 

[Daal]

OK, this has been done since the 1970's since treasuries became collateral. Let me simply this. You can buy ANY bill, note or bond in cash and use 95% of that value for trading as collateral. You earn whatever the coupon is on that bill, note or bond. This has been around forever and anyone who has traded futures knows this because FCM's never paid interest on balances even when short term interest rates were at 15%!!!!!!!!!!. Perhaps you were not aware of this before and I suspect most people are not. This was very apparent in the 1980's because most commodity traders had who opportunity costs leaving cash balances at FCM's.

For brokers that allow you to buy bonds, its very natural to buy it and use it as collateral. The tricky part is when you have a broker that does not allow bond buying and perhaps even futures buying (I have a couple like these). It feels unnatural to go long something in another account, in order to 'earn' interest in the first account but its the right thing to do. I never read this sort of advice before perhaps because its a bit unusual but i think its right. its all one big account called 'your networth' anyway.

 

[sprstpd]

Consider me fairly ignorant on the topic of bonds (because I am). Suppose you use this bond strategy for income but while you are holding them, they decline dramatically. What is your strategy in this case? Does buying bond futures allow you to hold the bonds until maturity?