PFIX - PFIX: Buy It As A Hedge Against Higher Interest Rates

Summary

• PFIX owns a portfolio of OTC swaptions that hedge rising interest rates.
• Interest rates appear to be reaccelerating higher as the Fed is intent on 'higher for longer' and the economy is more resilient.
• The BOJ surprise is also sparking the unwind of billions in carry trades that are leading to higher interest rates around the world.
• I am a buyer of PFIX as a hedge.

The Simplify Interest Rate Hedge ETF ( PFIX ) provides a hedge to investors worried about rising interest rates through a portfolio of OTC swaptions. Long-term interest rates are reaccelerating higher as the BOJ's surprise move to increase the 10Yr JGB interest rate cap is causing billions in carry trades to be unwound. I am a buyer of PFIX as a hedge.

Fund Overview

The Simplify Interest Rate Hedge ETF provides investors with a hedge against rising long-term interest rates. It also benefits when fixed income volatility increases. The fund has almost $400 million in assets as of December 28, 2022 and charges a 0.50% gross expense ratio (Figure 1).

Strategy

The PFIX ETF seeks to achieve its investment objective by primarily investing in over-the-counter ("OTC") interest rate derivatives that provide convex exposure to large upward moves in interest rates and interest rate volatility.

Historically, OTC derivatives are only available to institutional investors (think ISDA agreement the movie "The Big Short"). PFIX bridges the gap between retail investors and tools that institutional investors use to hedge / speculate on the path of interest rates.

According to the fund's marketing literature, the PFIX ETF is "functionally similar to owning a position in long-dated put options on 20-year US Treasury bonds". For investors in the PFIX ETF, this provides a simple and transparent interest rate hedge.

Looking at the fund's strategy in detail, the PFIX ETF will initially invest 50% of its NAV in 7-year OTC payer swaptions (pay fixed, receive floating) on the 20-year treasury rate struck at 4.25%. The swaption benefits as interest rate rises. The option is reviewed and reset periodically or after extreme interest rate moves. PFIX chooses an extended term and strike to minimize the cost of ownership (less rebalancing) and maximize convexity.

Portfolio Holdings

Figure 2 shows the PFIX ETF's holdings as of December 28, 2022. The ETF currently holds 33.4% net assets in swaptions paying between 4 and 4.25% against major investment banks such as Goldman Sachs, Bank of America, and Morgan Stanley.

Returns

As 2022 has been characterized by global central banks raising interest rates at the fastest pace in hisotry to combat inflation, PFIX has been a primary beneficiary. YTD to November 30, 2022, the PFIX ETF has delivered 84.8% returns in its NAV. Since its inception on May 10, 2021, the fund has returned 38.4% annualized (Figure 3).

Distribution & Yield

The PFIX ETF pays a nominal trailing 12 month distribution of $0.45 /share or 0.6%.

BOJ Triggering Next Phase Of Bond Volatility?

A few weeks ago, I wrote in an article on the ProShares UltraPro Short 20+ Year Treasury ETF ( TTT ), suggesting the period of interest rate increases was coming to an end, as investors start to price in a recession in 2023 and the Federal Reserve pivot to lowering interest rates.

However, in hindsight, my call may have been premature, as the U.S. 10-year treasury yield began heading higher in recent weeks, reversing near the important support level around 3.50% (Figure 4).

A number of reasons appear to be driving this reacceleration in interest rates. First, the Federal Reserve reiterated its hawkish 'higher for longer' stance at its most recent FOMC meeting on December 13-14. This message is in stark contrast to investors' expectations for the Fed to start lowering interest rates in H2/2023.

Second, economic data released in the past few weeks were actually stronger than expected, with U.S. GDP growing at an annualized 3.2% in Q3/2022. Ironically, good data is now considered bad, as it gives the Federal Reserve cover to stick to its 'higher for longer' policy.

Finally, perhaps the most impactful short-term reason for the rise in interest rates was the surprise move on by the BOJ to raise the yield limit for 10Yr JGBs to 0.50%, from a previous limit of 0.25%. The 'BOJ Christmas Surprise' caught many investors off-guard, as most had been expecting changes to BOJ policy only after Governor Kuroda's term ends in April 2023.

10Yr JGB yields jumped almost instantaneously to the 0.50% target, even as the BOJ stepped in with unlimited bond purchases . This BOJ move appears to have sparked a reacceleration of global bond yields, with German 10Yr yields now above their October highs at 2.50% and U.S. 10Yr yields rapidly rising as well (Figure 5).

BOJ May Have Blown Up The Yen Carry Trade

Recall, the Japanese Yen is the funding currency behind tens, if not hundreds of billions, in 'carry trades' - a macro trade where investors borrow at ultra low Japanese interest rates and invest the proceeds in higher yielding assets. The 'BOJ Christmas Surprise' caused the Yen to jump the most in 24 years and likely blew up many carry trade investors, as leverage is typically used to magnify the carry trade returns. As carry trades are unwound, foreign assets like U.S. treasuries are sold off, leading to rising interest rates.

Furthermore, with higher interest rates being offered domestically, Japanese investors have less incentive to invest in foreign assets like U.S. treasuries.

PFIX vs. Inverse ETFs

For investors looking to hedge interest rate exposure, I believe the PFIX ETF may be a superior vehicle compared to inverse levered ETFs like the TTT. This is because of the structure of their investment portfolios.

While both the PFIX and TTT offers convex returns against rising interest rates, if the 'path' of interest rate increase is volatile, the PFIX ETF should outperform, as it does not suffer from volatility decay due to daily rebalancings (please refer to my prior articles on levered ETFs for a more detailed explanation of this term). Instead, the PFIX will have a daily theta decay charge that should be small in comparison due to the portfolio's long-dated nature.

For example, the PFIX has outperformed the TTT on a 1 and 3 month timeframe (Figure 6) as the past few months have been characterized by increased volatility.

In fact, as 10Yr interest rate rises to the strike price of PFIX's swaptions (4% to 4.25%), we should expect the value of its portfolio to increase in a convex manner.

Conclusion

The PFIX ETF provides a hedge to investors worried about rising interest rates through a portfolio of OTC swaptions. Long-term interest rates are reaccelerating higher as the Fed is sticking to its 'higher for longer' policy and the economy appears more resilient than expected. Most importantly, the BOJ's surprise move to increase the 10Yr JGB interest rate cap is sparking a new wave of interest rate volatility, as billions in carry trades are unwound. I am a buyer of PFIX as a hedge.

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