Investing in T-bills (Part 16)

Last time, I began to explore the idea of trading options on top of tax-exempt munis since interest on T-bills is taxed at the Federal level. Today I continue the discussion with regard to maintenance margin requirements.

Let’s define two new terms: initial margin and maintenance margin. Initial margin is the percent of purchase price that must be paid with cash in a margin account. Maintenance margin, currently set at 25% of the total securities value per Financial Industry Regulatory Authority requirements, is the amount of equity that must be kept in the margin account going forward.

Maintenance margin for equities is best illustrated by a table:

• A margin account is opened by depositing $10,000 (column D).
• Using the $10,000 free cash and $10,000 borrowed from the brokerage (column E), 200 shares of XYZ are purchased at $100/share causing an equity percentage [col G = 100 * (col C – col E) / col C] drop to 50%.
• Equity percentage drops further as the share price drops.
• When XYZ hits $66.67/share, equity percentage is at the minimal threshold of 25%.
• At $66.50/share (a drop of 33.5% from initial purchase price), equity percentage is below threshold. Brokerage will issue a margin call forcing deposit of more cash or securities to avoid sale of XYZ at a big loss.
• Depositing an additional $1,000 (now $11,000 total in column D) restores equity percentage (30.1%) above the minimum threshold where it will remain unless XYZ drops to $61.50/share resulting in a subsequent margin call.

Although taxable, T-bill interest qualifies for 1% initial and maintenance margin for maturities up to six months. This means $100,000 of T-bills may be purchased while preserving $99,000 for option trading. Beware, though! This defines how much capital may be borrowed rather than how much should be invested. As stated in this third paragraph, capital should never be borrowed to invest in T-bills. T-bill investments count 100% against the cash balance* and margin loans begin if cash balance drops below zero (hence the 10% cash buffer mentioned in this second-to-last paragraph).

For the sake of option trading, low maintenance T-bill margin seems like a great deal that is actually just a necessary precaution (see bottom of Part 8) to prevent the brokerage from pocketing additional interest. While the customer gets paid 0.35% on free cash, the brokerage could invest that cash in T-bills to make 5% or more. I need to do more research to determine if this actually happens, but it seems plausible since T-bills are about as safe as any investment can get.

Disadvantaged margining for munis likely offsets their tax-exempt benefit. At my brokerage, initial and maintenance margin are the greater of 20% of the market value or 7% of the face value. I see another brokerage listing maintenance margin at 25% of bond market value (and initial at maintenance margin x 1.25). Either way, munis eat up at least 20x more in buying power than T-bills making them more likely to hamper option trading.

Next time we will study de minimis.

* — In contrast to naked puts that, as discussed in this last full paragraph, raise cash balance.