The ETF provides the best hedge in sudden down markets via its structure, while prolonged recessionary periods will cause its profile to match HYG's.
The Simplify High Yield PLUS Credit Hedge ETF (NYSEARCA:CDX) is a fund we wrote about twelve months ago. The exchange-traded fund is a fairly new addition to the fixed income arena, and it aims to deliver junk bond returns with an embedded market hedge. We have written numerous articles recently highlighting that credit spreads are currently at the bottom of their historic range, therefore buying high yield credit here is not an optimal choice.
However, for those investors who need that sectoral allocation in their portfolios irrespective of market conditions, we are going to highlight in this article why buying CDX over other plain vanilla HY ETFs is a smart choice.
The fund is designed to compete with the iShares iBoxx $ High Yield Corporate Bond ETF (HYG) and the SPDR Bloomberg High Yield Bond ETF (JNK):
In the past year, CDX has managed to outperform both its competitors, with a slightly better drawdown profile. The outperformance is massive, especially since CDX has a cost of carry associated with its hedging endeavors.
A 'hedge' is an insurance policy:
A hedge is an investment that is selected to reduce the potential for loss in other investments because its price tends to move in the opposite direction. This strategy works as a kind of insurance policy, offsetting any steep losses in other investments.
Every time an investor is concerned about market losses, and they purchase an S&P 500 put in their account, that is considered a hedge. There are various ways to hedge a portfolio, but the idea to be understood here is that an investor or a fund has an offset via a different financial instrument if a market storm were to occur.
This is the differentiator for CDX, which utilizes S&P 500 put spreads in order to hedge downside moves:
We can see the ETF containing two put spreads - one for June and one for July. Put spreads are a cheaper form of insurance, and they consist of buying a higher strike put and subsequently selling a lower strike one. Let us look at the June put spreads - the fund bought the 5200 strike puts and sold the 5000 strike ones. Therefore, if we have a significant market sell-off that takes the index below 5200, the structure will benefit from a positive mark-to-market coming from this put spread. Versus an outright put purchase, the put spread has a defined maximum positive performance.
Similarly, for July, there is a 5200/5000 put spread in place. There is a cost associated with put spreads (i.e. negative carry), and it is encouraging to see that on a 1-year lookback CDX was able to outperform vanilla ETFs even with the embedded cost of hedging.
The embedded hedge profile in CDX via put spreads, which we discussed above, will result in a lower drawdown for the fund during the next market sell-off. We are concerned with the current low level in credit spreads, and are of the opinion that we will see a significant widening during the next risk-off event.
High yield bonds and equities have a very close correlation, and a downturn in high yield credit should also see the SPY move lower. This in turn will result in the put spreads that CDX contains to become more valuable.
A retail investor can replicate this strategy in their own account by buying HYG while simultaneously buying rolling 1-month put spreads on the SPY index. However, this is more cumbersome and operationally intensive than just buying CDX outright in a size that fits any investor's portfolio.
A retail investor needs to understand that buying CDX still represents a long position in fixed rate high yield U.S. bonds, thus a significant market downturn and recession will have an adverse impact on the name. The embedded protection via SPX put spreads is designed to limit the downside for a short period of time, with a structurally down market resulting in significant losses for all high yield ETFs.
CDX's put spread hedges do best in a sudden vertical drop in risk markets. A prolonged step-down market will provide the least 'hedge' via CDX, since its put spreads might not get triggered in such a scenario.
CDX is a fixed income exchange-traded fund from Simplify. The fund aims to replicate larger, better known HY ETFs such as HYG, but with embedded hedging features. We are concerned about the low levels in credit spreads currently, levels which will move up significantly in a market downturn. In our opinion, for investors who need an HY allocation in their portfolios, CDX represents a better risk/reward proposal currently when compared to HYG or JNK. The fund has shown it can manage its negative cost of carry for its hedges, outperforming HYG/JNK in the past year from a total return perspective. CDX is best set-up to protect investors from a sudden sharp downturn in the markets via its put-spread options, but will have a similar downside profile as HYG in a long, protracted recessionary market.