IVOL: Massive Upside From Yield Curve Steepening

The Quadratic Interest Rate Volatility and Inflation Hedge ETF (NYSEARCA:IVOL) is a complicated ETF offering retail exposure to advanced interest rate derivatives, which are generally only available to institutional traders. IVOL presents a simple way to take a hyper-convex bet on the steepening yield curve and the overall macro dynamics which are occurring today.

This thesis boils down to a few factors:

• The yield curve is steepening, particularly the gap between the 2yr and 10yr

• Inflation will be returning soon for a myriad of macro reasons, mostly to do with money printing and the growing debt burden of the U.S. government

• Long-term yields will continue to expand, while short-term yields could fall from here

• IVOL’s options are a pure play medium term bet on these yield curve dynamics. Its other holdings do not impede the thesis, and are mildly helpful.

First, I’m going to go over how exactly IVOL works because the product is pretty complicated.

The Components of IVOL and Implications

IVOL holds TIPS in the form of Schwab U.S. TIPS ETF (SCHP). These are government bonds where the principal adjusts based on the CPI. When the CPI increases, the principal increases and the coupon adjusts to match this principal. The result is a risk free, government backed security which is protected from CPI inflation.

SCHP price seems to be a leading indicator for increases in the CPI. In other words, market expectations of the CPI are expressed via SCHP. Here is a plot of the percent changes in median CPI overlaid with the SCHP price.

SCHP’s price action (in red) clearly predicted both the rise and fall of the CPI percent change (in blue) after 2019. The TIPS market seemed to be anticipating an increase in CPI back in 2012, but this did not materialize, and SCHP promptly fell back to late 2011 levels by 2013. Inflation expectations aren’t always right, even if they are market-based. The last two major directional predictions, however, were pretty accurate.

SCHP occupies 79.4% of net assets, so understanding SCHP is definitely important to understanding IVOL. But SCHP is quite simple compared to the other positions.

Aside from a 7.6% cash position, the remaining 13% of IVOL is invested in options on constant maturity swaps (“CMS”) on the yield difference between the 2yr and 10yr U.S. treasuries. These are sometimes called swaptions, since they are options on swaps. The constant maturity aspect means that the underlying index that these swaptions reference is whatever is the current 2yr and 10yr yields at the time we are talking about. Swaptions, as derivatives, derive their value from the value of this underlying index: 10yr yields minus 2 year yields.

Options also have strike prices and expiries. Both numbers are written in the table. For instance, “USD CMS 2-10 04/08/2026 5” means an option on the CMS of 2yr and 10yr expiring on 8 April 2026, with a strike of 5 basis points. When the 2-10 spread is over 5 basis points, this contract will be ITM. You can see the current 2-10 constant maturity spread on the FRED website. It is -5 bps, up from -47 bps, a local bottom set in June.

The highest strike on this list, or the furthest OTM, is 30 bps, and it is expiring in November 2024. The lowest strike, or the closest to the money, is 3 bps, expiring in early 2026. This is just 9 bps away from being ITM, since we are currently at -5 bps.

These OTC options make IVOL a truly unique product, and they offer some tremendous convexity for your investing toolbox. Let’s see how this portfolio of options has performed in the last few months, in which the 2-10 has moved quite a bit. To isolate the performance of the options, we have to isolate the performance of SCHP and back it out of IVOL’s holdings.

At about 79% of the portfolio, SCHD’s 2.4% increase from 30 April contributed to around 1.9% (multiply 79 by 2.4%) of the 4.73% total gains experienced by IVOL over this time. This means the remaining 2.83% (4.73%-1.9% = 2.83%) came from the options. The options are about 13% of the portfolio, so for 13% of the portfolio to lead to 2.83% total portfolio returns, that 13% needed to increase by about 21.7% (13 x 0.217 = 2.82). Now, remember that the current 13% allocation to options happened after this increase, so the real increase in the options must have been larger. We can use 22% as the floor amount.

So how has the 2-10 underlying moved since 30 April? Well, here is the chart from FRED, and it shows -35 bps. Since we are at -5 bps today, it means the change has been a 30 bps increase since 30 April, and this has pushed up the options by at least 22%.

But none of the options are ITM yet. And options are also nonlinear. Gamma, the second derivative of the option price with respect to the value of the underlying, maxes out when the contract is ATM. All the contracts right now are OTM, but they are approaching ATM, so gamma will increase from here before falling once the options are ITM. Gamma is like the acceleration of how fast the option value goes up as the underlying moves in the favorable direction.

The takeaway is that if 22% was for 30 bps in the right direction, then the next 30 bps will see a lot more than a mere 22% increase from the options holdings, thanks to the higher gamma and delta (the delta increases faster because of the higher gamma). In fact, another 30 bps will send about half of the contracts ITM. At that point, the delta of the options should be mostly above 0.5, and gamma will start decreasing, so delta will not increase as fast as it has been increasing prior to the option going ITM.

The question here is, how likely is it for the 2-10 spread to continue higher? Luckily, the yield curve is steepening, which means the 2-10 should be entering positive territory soon. Also, a lot of macro dynamics are shaping out for short-term yields to collapse while long-term yields rise. There is pressure on both ends of the yield curve.

General Trend Based on Historical Yield Curve Data

I think the general direction for the 2-10 spread is up. We’ve had an inversion for a while now, and a return to normal would mean a prompt surge to 100 bps or at least 50 bps within the next year. Either of these would cause all the options held by IVOL to be pretty deep ITM.

History shows that this would also be followed by a recession, and it seems we might be near that point given the Sahm Rule being triggered and weaker than expected employment numbers. The chart looks to have bottomed back in mid-2023, and we are well on our way to a normal upward sloping yield curve, which means positive territory for the 2-10 spread.

While the historical trends look like they are in favor of IVOL’s options, let’s look at some macro dynamics too.

Short Maturities Down Due To Easing and Debt Monetization

The market has been pricing in rate cuts for a while, and Jerome Powell has explicitly stated that a cut might be on the table for September. At this point, the Fed might cut given the Sahm Rule and with many calls from politicians to cut rates heading into the election. Even though we are nowhere close to the target 2% inflation rate, the Fed might have to prioritize the other part of their dual mandate and take care of unemployment.

A rate cut would push down near term interest rates. The longer-term rates are hard to control, and rate cuts won’t impact the 10yr yields as much as they will impact the 2yr. This is the main reason I think the 2yr will fall, which contributes to a steepening yield curve on the front end.

The other reason is that there is a maturity disparity between the people who actually hold U.S. debt. You see, the Fed tends to hold more near term debt which matures in under five years. Foreign holders of U.S. government debt tend to prefer longer-term debt, maturing in 10 years or more. Now, the demand for near term debt, because it comes from the Fed, will always be there. This will have an effect of pushing up the price, and pushing down the yield for the shorter maturities.

Other holders of shorter maturities are commercial banks and, very recently, the major stablecoin issuers Tether and Circle. Crypto is a growing component of this conversation because Tether is actually the 18th largest holder of U.S. debt. Now, the business model of stablecoins and banks are that they need shorter term maturities because these are more liquid and can usually be sold at par. Stablecoins in particular are crypto tokens which are backed by fiat in a bank reserve, so they need to be able to meet redemptions. The way Tether makes money is by holding mostly fiat and then shorter maturity U.S. government bonds and bills to collect the risk-free interest. They recently reported $1.3 billion in Q2 profits, so this business model is quite strong.

The bottom line is that these buyers of shorter maturity bonds are basically price inelastic. They will continue to do it even if the yield is low, and as long as things like USD stablecoins and bank deposits continue to expand, there will be demand for U.S. debt with short maturities. From Tether’s perspective, there is nothing else to do with their fiat reserves except to buy shorter maturity treasuries because anything else creates a possible default risk. As long as USDT keeps growing higher, the growth in the fiat they have can offset any drops in the yield they are receiving. This is the long-term tailwind which will compress yields in the front end of the yield curve, in my view.

Long Maturities Up Due To Money Printing and De-Dollarization

When we look at the buyers of longer maturities, we now see that these are buyers which are actively decreasing their exposure to U.S. debt. In other words, the back end of the yield curve does not have the price-inelastic buyers as the front end. The two biggest holders of longer maturity U.S. debt right now are China and Japan.

Both countries are dropping their holdings of U.S. debt. China is notably diversifying into gold reserves. While the other countries like the UK, Luxembourg, and Canada are picking up the slack, I think we cannot expect this to continue. For a full list of long-term securities holdings of foreign countries, you can reference the TIC’s data here.

Ultimately, the world is seeing the risks of being too dependent on the U.S. dollar, especially after the U.S. has weaponized the dollar in 2022 against a political enemy. Deglobalization goes hand in hand with de-dollarization, and this means there will be decreased demand for U.S. debt with long maturities, like the 10yr.

I think China is the obvious candidate for leaving the dollar because they are the biggest rivals of the United States, and they have long desired to fracture the dollar’s hegemony. They’ve taken actions like establishing a petro-yuan and the Belt and Road Initiative to create self-sufficient trade routes. These are all attempts to mirror the U.S. playbook which formed the foundation of the dollar hegemony via the IMF, World Bank, and petro-dollar system.

Japan is the largest foreign holder of U.S. debt, and it is having troubles of its own. It might be forced to sell a lot of its holdings to support a falling yen and dampen its inflation. When faced with demographic challenges and decades of ultra-low interest rates, the Bank of Japan is finally starting to harden the currency. Unfortunately, if they have exhausted the other options, then they might be a seller of long maturity U.S. debt. At the very least, they won’t be buying more.

I think these forces are a serious headwind for 10yr bonds, which means the 10yr yield can get quite high. As the U.S. prints more money to pay its burgeoning interest costs, this will lead to inflation caused by a devaluation of the dollar. This will make longer-term debt less attractive, especially as the variance of monetary inflation makes the future value of a dollar highly unpredictable. All of these will force the 10yr yield higher, which dramatically steepens the yield curve.

Inflation and Inflation Expectations

Inflation and inflation expectations are two different things. Expectations are what matters in markets because finance is a brutally forward-looking endeavor. SCHP trades based on expectations, as we’ve seen above. Yet, the TIPS held by SCHP adjust their principal amounts based on actual inflation, measured by the CPI. In the last 4 years, these expectations as expressed by the SCHP price action has proved quite prescient in predicting changes in actual CPI inflation. This means that IVOL has a large component that is based on inflation expectations, but it is ultimately backstopped by the increasing principals and coupon payments on TIPS due to actual inflation.

I think there is something to be said about the 2-10 being based on expectations, too. When inflation is high, it means that longer dated bonds must have an inflation risk premium attached to it to compensate for the fact that the bondholder is being paid back in devalued currency— the further in the future, the more devalued the payment. This is certainly one reason longer dated bonds tend to have a higher yield. When the yield curve is inverted, that is almost an expectation for disinflationary forces because the inflation premium is effectively negative.

In that sense, IVOL could be a great bet on inflation expectations picking up. I think that given the fact that government spending is quickly ballooning, and fiscal policy is dominating the economy, inflation expectations have to pick up soon. Even if they don’t, I think that all it takes is for one CPI print to look like the trend is reversing, and CPI inflation is rebounding. That will probably cause a quick selloff in the equity markets in anticipation of a further delayed rate cut. This should also sound the alarms and promptly shift investors to a more sobering attitude about inflation expectations.

SCHP Should Be Good Too

What about the SCHP portion of the portfolio? That 79% matters. And in this case, it seems like another tailwind for the long IVOL thesis. If we look at the time series of the 2-10 and the price of SCHP, we see that during the disinflationary era from 2010 to 2018, TIPS and the 2-10 spread seemed to move opposite each other. Notice how the blue line moves down then up then down again from 2010 to 2014 while the red line moves up then down then up again in the same time. This inverse relationship persists until mid-2018.

Then, after 2018, the correlation between the two time series started to become very positive. The dramatic rally in SCHP which began in earnest in 2019 was coincided by a dramatic rise in the spread between the 10yr and 2yr. This was just after the yield curve had inverted in mid-2019, which you can see with the blue line briefly dipping below the x-axis (which is 0). Then, the reversal of the 2-10 in 2021 also coincided with the topping out of SCHP.

What is uncanny is how the 2-10 has seemingly bottomed out in 2023 right around the time SCHP had bottomed out. The gap in time is just a few months.

My theory is that after three years of rate hikes starting in December 2015 and ending in December 2018, the market began to expect the inflation which was coming as a result of the QE performed during 2008 and 2009. By 2016, the market basically had 7 years of no serious inflation. This era saw a negative correlation between the 2-10 spread and inflation expectations because most people had anticipated CPI inflation following QE but were wrong.

When weakness started to show throughout 2018 after two years of rate hikes, the relationship between the 2-10 and TIPS (inflation expectations) flipped positive, and it has been ever since. I think there are holes in this theory, but overall my observation is that inflationary times (like the one we are currently in) and times when it feels like the Fed is not in control of the situation (like the one we are currently in, especially with today’s fiscal dominance) will see a positive relationship between the 2-10 and the value of TIPS.

This indicates that if both 2-10 and SCHP seem to be bottoming out, then both are probably headed higher. And that means that both the SCHP part of the IVOL and the options will see increases. Thus, SCHP should not be a hindrance to IVOL.

Back in 2021, the 2-10 peaked just before SCHP peaked, and it led to awful returns in the last three years for both ETFs. This time, the tailwind is incredibly strong.

What Can We Expect On IVOL?

I think we can estimate the value of IVOL with some scenarios. We know that the last 30 bps increase in rates led to at least a 22% increase in the value of the options. None of the options were ITM, which means their deltas were relatively small. Another 30 bps will push most of them ITM, and I think we can expect probably a +50% expansion from here. At 13%, this would add another 6% to IVOL’s NAV.

In a bull case, imagine an increase in the 2-10 spread, much like the move from -9 bps to 188 bps from February 2007 to February 2008. This could be crazy, but it wouldn’t be outside of the realm of possibility if we get two 25 bps cuts before March 2025 and Japan is forced to start selling some U.S. debt. More people from developing countries will move into USDT as their local fiat currencies become more unstable, and Tether would push down the short-term rates even more. This would be a 200 bps move, and the options with the highest strikes will be around 170 bps ITM.

At this point, deltas would approach 1 and every additional basis point would be a dollar added to the option value. Also, the option would be predominantly intrinsic value, so the difference between the strike and the spot. Let’s look at what they are currently worth. I divided market value by shares held.

At 188 bps on the 2-10 spread, most of these will be worth a bit over $160 intrinsic value, which is a 4x from current levels. Given the uniqueness of the macro setup of longer maturities possibly being sold unlike ever before and shorter maturities being bought unlike ever before, I wouldn’t be surprised if this spread hit an all-time high and crossed the 300 bps mark. This would be a 9x from current levels.

So with this napkin math, I see a possible 4-9x upside in the options. 4-9x on a 13% allocation could alone contribute to 52-117% returns for IVOL. The SCHP price appreciation from inflation and intermittent yield would just be additional returns on top. The time frame is within 1-2 years. After 15 months, some of the options on here will have expired, so the thesis becomes dependent on what new options the fund will roll into.

I view this as a pretty compelling opportunity because if we do have a recession from a steepening yield curve (and recession tends to happen when the curve un-inverts and steepens), then IVOL is likely one of the best growth ideas out there. It might be worth taking a small, speculative position just in case.

Risks

The main risk is I get the direction wrong and both SCHP and the 2-10 go down from here. This would be awful for IVOL’s NAV. The options would mostly expire worthless in 2-3 years, and that would take 13% off the top. But this would also mean that the yield curve continues to remain inverted, which seems very doubtful to me.

Another risk is if there is a separation between the 2-10 and TIPS. If suddenly the correlation flips to being negative like it was before 2018, then IVOL could still suffer because SCHP would go down, and the options would go up, or vice versa. We really need both things to happen for this thesis to play out well.

I think another scenario, though this is not an IVOL-only risk, is that the fragility in the financial system just becomes too much over the next two years. We could possibly see decimation in the value of TIPS if money printing gets out of control, while CPI baskets are purposefully adjusted to drastically understate true inflation. This would hurt a lot of securities, but it could cause the SCHP component to crater. While the long volatility positions could save the NAV, it might still create an unacceptable situation for risk-averse investors. There is evidence that CPI baskets do, in fact, substitute for cheaper goods, and an extreme version of this could see TIPS becoming treated as little better than normal government bonds.

Conclusion

I view IVOL as a pretty reasonable but speculative bet at this stage in the economic cycle. I’ve laid out the core reasons for why I think short-term rates will go down, and long-term rates will go up, returning the 2-10 to over 100 bps, which could give IVOL explosive upside in the next two years.

IVOL is worth serious consideration as a speculative long which could yield serious upside. It also exhibits low correlation to other assets. I think this alone makes it attractive from a portfolio construction perspective. If this historic low correlation holds up, then it might be a strong candidate for outperformance this cycle.

Beware that this is a macro bet on the relative direction of interest rates, as well as future inflation expectations. These are not always straightforward to predict. With 13% going into exotic derivatives and 79% going into potentially unexciting TIPS, this is not going to be a position for everyone. I just think the risk-reward looks quite excellent.

Editor’s Note: This article was submitted as part of Seeking Alpha’s Best Growth Idea investment competition.