IVOL - IVOL: Time To Buy Bonds And 2s10s (Rating Upgrade)

2023-11-08 21:10:01 ET

Summary

• The Krane Shares Trust - Quadratic Interest Rate Volatility and Inflation Hedge ETF is a unique exchange traded fund.
• The ETF contains two main risk factors, namely a long position in US TIPS bonds and a bet on the normalization of the 2s10s curve after a historic inversion.
• The fund's performance is expected to improve as the Fed maintains a neutral stance and the 2s10s spread narrows.
• IVOL offers retail investors access to the 2s10s relationship, which is not easily accessible to U.S. based investors.

Thesis

The Krane Shares Trust - Quadratic Interest Rate Volatility and Inflation Hedge ETF ( IVOL ) is an exchange traded fund that falls in the rates space. We have covered this name before here , back in 2022, when we were still unhappy with the risk factors offered by the fund. We were correct in our view, with rates moving higher throughout 2023 and 2s10s widening to historic levels. The fund is down over -6% since we last took a look at the name:

The landscape going into the end of 2023 looks very different though, with the Fed at what we consider a neutral level, and many market participants of the view that the rates rising cycle is over . Furthermore, after a historic inversion that exceeded 100bps, the 2s10s spread is finally narrowing, which should provide backwinds for IVOL's performance going forward.

IVOL risk factors and their forward

There are two main components in the IVOL ETF:

1. A large position in the Schwab U.S. Tips ETF ( SCHP )
2. And a ladder of swaptions betting on the normalization of the 2s10s spread

SCHP is an inflation-protected U.S. Treasury securities fund that has a duration of 6.5 years. The vehicle has been pummeled in the past years by the higher rates complex:

As rates have moved up, SCHP's value has declined. With the Fed set on neutral for now and market participants anticipating rate cuts mid 2024, SCHP will deliver going forward both from a yield and price perspective.

2022 and 2023 have been the years where short bond positioning has paid off. Going forward we are of the opinion that the long bond trade will be the value creator, given where current yields find themselves.

The more interesting aspect of IVOL is composed of its 2s10s swaptions. Firstly 2s10s is financial nomenclature for the difference in interest rates between the two-year and ten-year Treasury bonds. It is not a complex equation, it purely represents the difference in yield between the on-the-run 2 year treasuries and on-the-run 10 year treasuries. If 2 year rates are higher than 10 year rates then we get a negative number and an inverted yield curve. Historically the yield curve inversion is a predecessor to recessions:

As we can see from the above graph, each time in modern history that we had a negative 2s10s spread, we eventually got a recession, which resulted in the yield curve normalization via term premium. A yield curve normalization simply refers to front rates being lower than long rates. That translates into a positive spread, and the line in the above graph being higher than 0%.

The deeply inverted yield curve was the result of the Fed hiking rates very fast, while the market did not believe higher rates would last for a long period. The recent 'higher for longer' Fed rhetoric has resulted in long rates being bid higher, and the negative spread normalizing:

This is the same relationship graphed via YCharts that shows how the spread peaked at -1% (or 100 bps differential) in July, having retraced a significant portion as long rates have moved higher.

Make no mistake about it, the spread relationship will follow its historic precedent and move into positive territory when the Fed starts cutting rates and we see the front end of the rates complex move down significantly faster than the long end. IVOL is set to benefit via its swaptions:

The 'USD CMS 2-10' collateral lines reference various swaptions the fund has on, with different maturity dates. The closest one is in November 2023, while the longest one goes out to 2026. As the 2s10s spread moves to positive territory the above derivatives will gain in value, adding to the fund performance.

Analytics

• AUM: $0.9 billion.
• Sharpe Ratio: -0.71 (3Y).
• Std. Deviation: 10.15 (3Y).
• Yield: 3.7%.
• Premium/Discount to NAV: n/a.
• Z-Stat: n/a.
• Leverage Ratio: 0%.
• Effective Duration: 6.5 yrs (implied via largest holding)
• Composition: US Tips + curve steepener

IVOL - understanding what you are buying

While initially the fund was marketed as a risk hedging tool, it has subsequently revised its stance and correctly identifies what the ETF achieves for investors:

VOL is a first-of-its-kind ETF which is designed to hedge the risk of an increase in fixed income volatility and/or an increase in inflation expectations. It also seeks to profit from a steepening of the yield curve, whether that occurs via rising long-term interest rates or falling short term interest rates, which are historically associated with large equity market declines.

Via IVOL a retail investor is purchasing U.S Tips with a 6.5 year duration and buying into the 2s10s yield curve relationship. The risk factors which drive the returns of this fund are thus rates, and the steepness of the curve.

To our knowledge outside IVOL a retail investor has no other way to access the 2s10s relationship, which can be easily done by institutional investors via swap contracts. Retail investors however cannot do over the counter swaps. There is a product offered in Europe called the 'LYXOR US CURVE STEEPENING 2-10 UCITS ETF', but this is not accessible to U.S. based investors.

Conclusion

IVOL is an exchange traded fund. The vehicle caters to rates investors via its long position in SCHP and its 2s10s steepener trade. The fund has had a rough two years with rates higher and the curve inverting. With the Fed now on a neutral stance and the market pricing in significant rate cuts for 2024 via Fed Funds futures, we are of the opinion that both risk factors that drive returns for IVOL will produce positive results in the next 12 months. Moreover, IVOL is a unique product in terms of offering retail investors access to the 2s10s relationship, something that institutional investors easily achieve via exchange cleared or over the counter swaps. We are therefore a Buy for the fund at the current levels.

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