PFIX - PFIX: Leveraged Short On Long Bonds Time To Divest

2023-11-10 05:39:28 ET

Summary

• The Simplify Interest Rate Hedge ETF (PFIX) is an ETF that aims to hedge against higher 20-year rates and profit from fixed income volatility.
• The fund exhibits the pay-off profile of a 3x treasury bear fund, and has closely tracked the Direxion Daily 20+ Yr Trsy Bear 3x ETF (TMV).
• The thesis argues that the Federal Reserve is unlikely to raise rates further, and long-term rates are expected to decrease.
• After a 34% gain this year on the back of higher rates, the fund is set for significant loses if 20-year rates go down by 100 bps in the next 12 months.

Thesis

The Simplify Interest Rate Hedge ETF ( PFIX ) is an exchange traded fund from the Simplify family. So far the products analyzed from this asset manager tend to be on the complex side and a retail investor needs to ensure they fully understand them prior to engaging in long or short positions. PFIX is no different. As per its literature:

The fund seeks to hedge interest rate movements arising from rising long-term interest rates and to benefit from market stress when fixed income volatility increases. T­he fund holds a large position in over-the-counter (OTC) interest rate options intended to provide a direct and transparent convex exposure to large upward moves in interest rates and interest rate volatility. Using OTC derivatives, usually only available to institutional investors, PFIX is designed to be functionally similar to owning a position in long-dated put options on 20-year US Treasury bonds. Since the option position is held for an extended period, the ETF provides a simple and transparent interest rate hedge.

On a first glance an investor gets a sense that the fund uses swaptions to create a position similar to owning puts on 20-year US Treasury bonds. As rates go up and bond prices go down, PFIX should gain in value. Which it does. However, what the fund fails to mention is that PFIX is very much akin to a -3x leveraged position on long dated bonds:

The fund has a return profile almost identical to the Direxion Daily 20+ Yr Trsy Bear 3x ETF ( TMV ), which is a leveraged ETF that gains in value when long rates go up and bond prices go down.

In this article we are going to talk about our view on peak rates, the actual leveraged risk factor that PFIX introduces in a portfolio, and our opinion that a retail investor is best served to Sell out of PFIX at this stage of the monetary cycle, in anticipation of a violent sell-off in PFIX in the next 12 months.

PFIX Composition and its embedded hidden leverage

On a first glance a retail investor would not be able to ascertain that there is leverage embedded in this structure due to the complexity of the collateral and payoff profile. Traditional leveraged ETFs are very straight forward about what they are trying to achieve and they have total return swaps that clearly state their intent to provide 3x the daily return of a certain index. Not PFIX. What they disclose is the following:

Initial investment of 50% of NAV in 7-year OTC payer swaption on the 20-year rate struck at 4.25%, providing direct exposure to rising rates

Source: Fact Sheet

That translates into the fund taking a position in the following swaption:

A swaption is the option to enter into a swap. The respective instrument is the option to enter into a 20-year swap 7 years from now. The OTC market is fairly complex and you can trade a number of relationships to achieve a certain duration profile. In the above table, courtesy of Bloomberg, on the top horizontal line you can find the tenor of the underlying swaps, while on the left vertical bar you can find the start date. You can buy an option to enter into a 20 year swap for a start date 1 month away, or a start date 25 years away. Ultimately the instrument you choose will have a certain sensitivity to interest rates and volatility. The swaption chosen by PFIX gives a pay-off profile very similar to a -3x leveraged position in 20-year bonds, but the risk factor is well hidden.

Performance - leveraged take on 20-year rates

Let us have a closer look at PFIX's performance versus a self-declared leveraged fund like TMV:

The main risk factor here is constituted by 20-year rates. TLT is the long bond fund that provides investors with exposure to that node in the yield curve. TLT is down -36% in the past two years. TMV achieves its goal to provide a -3x return, clocking in 127% (36% x 3 = 108%), while PFIX returns 92% on a price basis, also a rough -3x return versus TLT.

The performance graph therefore tells the same story of PFIX actually being a leveraged 3x bet on 20-year bonds losing value.

Rates have peaked

As a rule of thumb, as a retail investor, one should be extremely careful with leveraged products because they can gain value fast, but also lose value quickly. In our view the Fed is done raising rates this cycle, and the market is starting to price that in via a massive rally after the Fed kept Fed Funds at the same level last week. In a nutshell, we have seen long rates go higher on the back of the 'higher for longer' stance from the Fed, and fears around more hikes. A neutral stance followed by a cut next year in Fed Funds will see long rates move lower, all else equal.

To that end, let us do a rough estimate of the impact on PFIX from a 1% move lower in 20-year rates:

We know that TLT has a 17 years duration, therefore a move lower in 20-year rates by 100 bps should generate a 17% gain in TLT, and a rough -51% loss in PFIX by using the historic correlation and leverage factor observed for the name.

A retail investor at this stage is best served by divesting highly leveraged products like PFIX and crystalizing gains. In our opinion the tightening monetary cycle is over, and the Fed is now in a neutral mode given the continued run-off in their balance sheet and the hidden tightening achieved by long rates having moved higher.

Conclusion

PFIX is an exchange traded fund focused on rates. The vehicle takes a position in swaptions on the 20-year rate that achieve a return profile akin to a 3x leveraged ETF on 20 year bonds. As rates move up and bonds lose value, PFIX gains. To that end TLT (a 20-year bonds fund) is down -36% since July 2021, while PFIX is up roughly 3x at 92% and the Direxion 3x product TMV is up 127%.

A retail investor needs to be very careful with products with such a pay-off profile since they can lose value very fast, similarly to their explosive gains. We are of the opinion that we have witnessed peak long rates, with the next move to be lower. A rough estimation for a 100 bps move lower in 20-year rates gives us an estimated -51% negative return for PFIX. We are therefore a Sell for the name, anticipating a violent move lower in the next 12 months.

For further details see: