PFIX - PFIX Has A Lot Left In The Tank

2023-10-06 13:07:42 ET

Summary

• Simplify Interest Rate Hedge ETF is an interest rate hedging instrument that invests in US Treasury bonds and uses swaptions to benefit from rising interest rates.
• The PFIX ETF will likely benefit from the current higher for longer interest rate environment and yield volatility.
• The PFIX ETF currently trades at a discount, seemingly driven by a growing asset base.
• A developing dividend profile coupled with the potential for diversified returns places this ETF near the top of our buy list.

Today's analysis covers the Simplify Interest Rate Hedge ETF (PFIX). As its name hints, the Simplify Interest Rate Hedge ETF is an interest rate hedging instrument with additional benefits that remain sparsely covered by research analysts.

Methodologically, today's article aims to address two questions, which are: Is PFIX still undervalued? And what additional functions does the fund serve?

Let's get stuck in.

Fund Overview and Strategy

Basic Strategy

The Simplify Interest Rate Hedge ETF invests in U.S. Treasury bonds to gain basic fixed-income exposure and benefit from higher coupons when interest rates rise. However, higher interest rates usually result in lower bond prices, often throwing curveballs at investors.

Enter interest rate options, also known as swaptions. Interest rate options can adjust an investor's interest rates paid or received. For instance, a fixed-rate payer can adjust to a variable-rate payer, or a fixed-rate receiver can adjust to a variable-rate receiver, and so forth.

The Simplify Interest Rate Hedge ETF's strategy enters pay-fixed and receives floating swaptions, allowing it to benefit from rising interest rates. Sure, this could backfire if interest rates curtail; however, the fund will likely immunize or reverse its strategy in such an event.

Higher interest rates will still devalue bonds. However, if this ETF's strategy remains static, it will likely recoup its price losses with gains from its options on interest rates.

Let's delve into the fund's secondary effects to explain why it can recoup bond price losses with a small volume of swaptions.

Secondary Effects

Options usually present asymmetrical returns, meaning convexity comes into play with swaptions. Moreover, options do not merely rely on the underlying instrument's price. They rely on other factors such as volatility, time decay, the rate of change in the option's change versus the underlying, and the risk-free rate (which is doubly priced in the case of Swaptions).

The Simplify Interest Rate Hedge ETF's fund literature explicitly states that the fund benefits from elevated interest rates and volatility. Therefore, I'd encourage you to revise the fund's material if you'd like to corroborate my previous statements.

Sure, Pearl Gray, thanks for the lecture; however, what does all this mean for Simplify Interest Rate Hedge ETF's investors?

It means that the vehicle can potentially benefit from the current higher for longer interest rate environment. In addition, the fund can still benefit from volatility if rates fail to rise.

According to Russell Investments , yield volatility remains exceptionally high across most durations. If the implied yield volatility is realized, the Simplify Interest Rate Hedge ETF's swaptions will likely rise, providing investors with much to cheer about.

Higher For Longer Interest Rates

Examining the U.S. yield curve's latest move (the blue line) communicates the possibility of a higher for longer environment.

I must admit, if you asked me six months ago, I would've said that we'd likely see the short-end level drop to about 4% by now, with a slope flattening in tandem. However, resilient oil and gas prices , high business inventory levels , and robust consumer demand in the U.S. mean higher for longer is the most likely outcome. In fact, another hike isn't out of the question.

The bottom line is that it would probably be smarter to hedge upside interest rate risk instead of betting on a decline at this stage. Yes, the latter can be profitable; however, it seems like a very unlikely outcome for now.

Shareholder Compensation

The Simplify Interest Rate Hedge ETF's dividend needs some time to grow as it is a relatively new vehicle.

Keep in mind that its dividends will likely be cyclical as the fund's income is dependent on interest rates. Nevertheless, I think investors will be satisfied with the Simplify Interest Rate Hedge ETF's dividend profile in the long term.

Discount/Premium

The Simplify Interest Rate Hedge ETF possesses a discount of approximately 0.34%, suggesting statistical arbitrage traders could soon be lured in. The fund's market price has increased by nearly 30% month-over-month. Thus, it doesn't seem like PFIX ETF's discount is due to lower price levels. Instead, it appears that its NAV has increased and is yet to be priced by the market.

Risks

I've identified two risks here, with the first being expense-related. Remember that the Simplify Interest Rate Hedge ETF is volatile, likely requiring frequent rebalancing of your exposure to the instrument, especially as most will probably use it as a diversification vehicle instead of a core holding.

As such, as an ETF, its bid-ask spreads and commissions might be undesirable to many. In fact, skilled investors would probably back themselves by dealing with exchange-traded options to cover volatility and interest rates in alternative ways instead of betting on an interest-rate ETF.

Further, the Simplify Interest Rate Hedge ETF's strategy is speculative. It has been proven repeatedly that interest rate and volatility forecasting is exceptionally challenging. Thus, investors must understand that the vehicle possesses significant operating risk.

Final Word

A systematic analysis of the Simplify Interest Rate Hedge ETF shows that it has room left to roam into as a higher for longer interest rate environment is becoming increasingly likely. Furthermore, the vehicle is aligned to benefit from secondary effects such as convexity driven by elevated volatility.

Although risks such as difficulties in forecasting swaption prices and high expenses exist, we deem the ETF a buy.

For further details see: