PFIX ETF: Providing Simple And Transparent Interest Rate Hedge

In order to curb exceptionally high inflation, the Federal Reserve has hiked the interest rates, and is expected to go for multiple hikes in the next two years. An increase in interest rates generally is detrimental for bonds. However, bond funds like Simplify Interest Rate Hedge ETF (NYSEARCA:PFIX) have certain advantages over traditional bond funds, due to their use of OTC derivatives, which are generally available only to the institutional investors. PFIX uses OTC derivatives in order to hedge against the rising interest rates. The strategy has almost the same impact as of that of owning long-dated put options on Treasury bonds.

Simplify Interest Rate Hedge ETF

Simplify Interest Rate Hedge ETF invests in U.S. Treasuries, U.S. Treasury Inflation-Protected Securities (TIPS) and investment grade bonds. TIPS are U.S. government bonds whose principal amount increases with inflation and are designed to protect investors from inflation risk. It invests either directly, or through other funds, or through derivatives such as swaptions and options. Almost two-third of its entire portfolio is invested in government securities. 96 percent of investments are either AAA or AA rated.

This ETF was launched and is managed by Simplify Asset Management Inc. This ETF was formed on May 10, 2021 and is domiciled in the United States. As the fund was launched only 15 months back, it doesn’t make sense to emphasize too much on its historical performance – be it price or dividend. However, it’s worth mentioning that the price performance had been exceptionally good during the past one year and the fund generated a price growth of almost 28 percent.

How Does the Strategy Work?

The investment strategy of Simplify Interest Rate Hedge ETF is unique. It invests half of its entire fund in 5 year treasuries, which provide a minimum income to the fund. The fund invests the other half of its assets in 7-year OTC payer swaption on the 20-year treasury rate. The fund profits from higher treasury rates, which are likely to increase due to 40-year record high inflation coupled with a prospect of strong economic growth in the long run. For those investors wishing to profit from increased interest rates, PFIX is an appropriate fund. Investors can look for double digit gains in case of interest rate hikes. Otherwise, they have to accept losses.

Let’s understand PFIX’s investment objective with an $50 million investment in 20 year treasuries yielding 1 percent. In case of rising interest rates, the yields will rise, but the treasuries will have a fixed interest rate. Irrespective of what happens in the market, or how much the monetary policy changes, the investment is stuck with that 2% yield for 20 long years. Now, if the same 1 percent treasury yield is swapped for a variable yield, e.g. 0.85 percent plus the Federal Funds rate, which may be somewhere a little less than 1 percent (due to spread enjoyed by the bank that swaps the interest rates). Now, higher Federal Funds rates automatically will lead to a higher yield, and the investment will no longer be stuck with a 1 percent yield.

PFIX Can be Helpful In an Environment of Rising Interest Rates

Simplify Interest Rate Hedge ETF has not paid a steady dividend and the yield is almost zero. This fund is not in a position to generate strong and steady pay-out as the portfolio of investments generates an average coupon of only 0.75 percent. This fund primarily aims to hedge on the interest rate movements, which primarily arises from rising long-term interest rates. T­he fund holds a large position in over-the-counter (OTC) interest rate options intended to hedge against upward movement in interest rates and interest rate volatility.

While Simplify Interest Rate Hedge ETF gains in case of increasing interest rates, the strategy will always be dependent on macro-economic factors. It’s true that the Federal Reserve is trying its best and somehow has been able to take a grip over short-term interest rates, however, the rising levels of inflation will still be the driving force for the longer-term bonds. As the economy and anticipated monetary policy is indicative of increasing interest rates, PFIX is also expected to benefit. However, like any other hedging strategy, a fall can’t be ruled out. If interest rates move downwards, the price of the options could go to zero, which will wipe out the investments in Treasury bonds and rated securities.

Investment Thesis

High inflation coupled with an economic slowdown, rising interest rates and the threat of a looming recession have combined to drive the S&P 500 Index down more than 16 percent this year. But, Simplify Interest Rate Hedge ETF is moving in the opposite direction with a portfolio of higher rated bonds and derivatives. The blend of five-year Treasury notes with seven-year put options on the 20-year Treasury bond’s interest, seems to be delivering results. This fund is perhaps the most simplistic way for investors to protect themselves against higher interest rates. Since the option position is held for an extended period, the ETF provides a simple and transparent interest rate hedge.

However, Simplify Interest Rate Hedge ETF comes with some additional risks due to its higher exposure to derivatives. PFIX buys put options on longer-term Treasury bonds in order to hedge against rising interest rates. As investors seek to protect their portfolio using options, advisors are looking for any sorts of additional income they can, particularly for their older clients who are in retirement. In that process lies the risk of selecting the risky investment option, as well as chances of losses in case of interest remaining flat or going down. Investors may suffer huge losses under such circumstances.

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