ETF PFIX: take advantage of higher interest rates
Almost a year ago I wrote about the Simplify Interest Rate Hedge ETF (NYSEARCA: PFIX), which offers investors an incredibly efficient way to take advantage of higher interest rates. Interest rates have significantly increased sinceSo I thought an update was in order.
The PFIX is expected to significantly outperform as interest rates, especially the 20-year Treasury rate, rise. The fund performed as expected, posting gains of more than 55% on a 1.5% rise in its benchmark rate. Results were outstanding, with the fund significantly outperforming most relevant asset classes, interest rate hedges and inflation hedges. Expect big gains if interest rates continue to rise, a distinct possibility as long as inflation remains high.
PFIX is a suitable investment for aggressive investors and traders looking to take advantage of higher interest rates. The fund’s complicated and leveraged holdings make it an unsuitable investment for more conservative investors.
Analysis of securities/interest rate hedging options
I’ll start with a high-level overview of the fund’s holdings and strategy. These haven’t materially changed since I last covered the fund, so feel free to skip this section if you’ve read my previous post on the subject.
PFIX strategy is quite simple.
The fund invests 50% of its assets in 5-year Treasury bills. These are simple holdings, which mainly provide the fund with some income.
The fund invests the remaining 50% of its assets in a 7-year OTC payer swaption on the 20-year Treasury rate. It’s not that simple assetsbut I have some experience with these and similar derivatives, so I hope I can explain how they work in layman’s terms.
Let’s say you’re a bank and you invest $100 million in 20-year treasury bills yielding 3.0%.
Treasury bills, however, have fixed interest rates. No matter what the Fed or the market does, you’re stuck with that 3.0% return for 20 long years. Good luck selling an old low-yielding treasury if rates go up too.
Not an ideal situation, but one with an easy solution.
Go to another bank and ask them to swap the Treasury’s 3.0% fixed yield for a variable yield. Let’s say 2.4% plus the federal funds rate, or 2.9% as of today.
Higher fed funds rates would immediately translate into higher returns, thanks to your counterparty.
Lower fed funds rates would immediately lead to lower yields, thanks to the same.
Intuitively, net profits depend on higher returns.
Less intuitively, net profits are likely to be negative because these swaps have costs. Costs usually take the form of spreads. In the example above, we traded a fixed rate of 3.0% for a floating rate of 2.9%, with the bank counterparty pocketing the 0.1% spread.
Banks and other large financial institutions use swaps like this to hedge their interest rate exposure.
It is important to note that swaps can also be used for speculation: simply buy the swaps without the treasury bills. This way, you potentially benefit from rising rates and don’t have to invest in low-yielding treasuries.
PFIX invests in assets similar to those above. Let’s look.
PFIX – Presentation and expected performance
PFIX invests 50% of its assets in a 7-year OTC payer swaption on the 20-year Treasury rate, with the remainder invested in Treasury bills. These swaptions are quite similar to the derivatives described above, with the caveat that the swaps only go into effect when 20-year Treasury rates reach 4.0%.
PFIX’s swaps are key to the fund’s strategy and expected performance. As derivatives, their characteristics are self-explanatory and well-known, and their performance depends directly on the performance of specific variables.
PFIX swaps are cheap because they only come into effect when rates have risen a lot. Insurance against the unlikely events is quite cheap, because the insurance company knows that reimbursements are unlikely. Same principle here. Incidentally, the costs are currently somewhat higher than medium, as interest rates have risen significantly, driving up the price of these swaps. Yet the costs remain low.
Because swaps are cheap, the fund can buy a lot of them, and therefore the fund is (implicitly) extremely leveraged. Expect big gains from relatively small interest rate moves. For example, 20-year Treasury rates have risen about 1.35% since the start of the year, from 2.0% to 3.35%.
The PFIX itself is up over 67%, fifty times the movement of the underlying benchmark rate. Massive gains and largely representative of the significant leverage implied in the fund’s swaps.
Since swaps don’t kick in until rates hit at least 4.0%, the gains start to increase massively as you get closer to 4.0%, and are relatively small when the rates are further away from 4.0%. For example, from July 2021 to January 2022, the Treasury rates went from 1.8% to 2.2%, but the PFIX was stable. Gains only resumed when rates rose above 2.5% and were quite solid when rates hit 3.0%.
Once rates get closer to 4.0%, the fund begins to make significant gains even with minor interest rate movements. For example, last week, 20-year Treasury rates rose 0.35% from 3.0% to 3.35%, while the PFIX rose more than 10%. Small movements in interest rates had no impact when rates were around 2.0%, but have massive effects now that rates are hovering between 3.0% and 4.0%.
A corollary of the above is that gains would be much higher if rates exceeded 4.0%. Benchmark rates are currently at 3.35%, having risen 1.365% since the start of the year, so we are not too far off from this scenario. In my view, rates are close enough to 4.0% that any further rise in interest rates will have outsized effects on the price and performance of the fund’s shares.
Since swaps have costs, expect large losses if interest rates move sideways (no profits minus costs equals net losses) for an extended period. For example, interest rates remained stable from the inception of the fund until January 2022, during which time the fund suffered losses of around 17%.
Since PFIX swaps have costs and profits are realized only if interest rates significantly rise, long-term returns are likely to be negative. Positive long-term returns would require significant and continued increases in long-term rates, which are possiblebut do not seem very likely.
Due to the above, PFIX is more suitable as a short-term trading vehicle than a long-term investment. Consider trading PFIX for short periods and consider locking in gains. As an aside, it seems that PFIX himself is that From what I saw, they sold several older swaps with lower strike prices as interest rates rose, locking in some gains. Since we don’t have detailed information on the specific trades made, I can’t really analyze the trades in depth, but it looks like the fund is trying to take advantage of gains and changing market conditions.
For investors familiar with options, PFIX swaps have some of the same characteristics as long-term OTM put options on 20-year Treasury bills. Both delta and gamma of interest rates are positive.
Due to PFIX’s highly leveraged holdings and options, a small allocation should be sufficient for the vast majority of investors. Extremely little reason to go above 10%, and even that is quite high. With a 10% allocation, expect a significant portion of gains, losses and portfolio exposure to be directly tied to long-term Treasury rates. A 10% allocation would have covered around 50% of the losses incurred by a stock/bond portfolio since the start of the year, a reasonably large amount. Diversification into commodities, energy, value stocks and the like would have covered the rest. I firmly believe that investors should err on the side of caution when dealing with complex leveraged funds, and that includes PFIX.
PFIX invests in cheap leveraged interest rate swaps. Expect double-digit gains from small interest rate increases, triple-digit gains from larger moves, if not losses.
By the way, all the scenarios and characteristics mentioned above were included in my first article on PFIX, when the fund was fairly new and did not have a long track record. Fact is, the above are/were forward-looking predictions of how the fund should perform under different scenarios based on my knowledge and understanding of the fund’s strategy and holdings. It performed as expected in all relevant scenarios, which I believe is important information for investors to consider.
PFIX – Investment Thesis
PFIX’s investment thesis is remarkably simple.
The fund would benefit from higher Treasury rates, which will likely continue to rise as long as inflation remains high. As such, the fund is a suitable investment opportunity for investors concerned about rising interest rates, inflation or both. Expect above-market returns if rates rise, as they have since the start of the year.
Due to the complex and leveraged holdings of the PFIX, the fund is only suitable for aggressive traders and speculators. Only invest in PFIX if you are comfortable with leverage, options and (potential) double-digit losses. PFIX sees double-digit gains on interest rate increases of 0.35%, it would see similar losses for interest rate decreases of similar size. Losses would be significant if inflation and rates normalize, and investors should be prepared for this eventuality.
Due to the complex and leveraged holdings of the PFIX, the fund is not suitable for more conservative investors looking for interest rate hedges.
Conclusion – Effective interest rate hedging
PFIX offers investors an efficient way to take advantage of rising interest rates.