Daily Stock Pick: December 9th, 2022

Stocks ticked lower this morning after November’s reading of the Bureau of Labor Statistics (BLS) Producer Price Index (PPI) came in hotter than expected.  The PPI tracks inflation from the standpoint of goods-producing businesses and is considered a bellwether for the trajectory of consumer inflation.  November’s PPI rose 0.3% from the previous month and 7.4% year over year, topping consensus estimates by 33%.

While all attention is focused on inflation right now, recession cycles come with a more substantial risk for deflation.  Today we’re highlighting an investment that provides access to a part of the market (until recently, reserved exclusively for large institutions) that can help hedge a portfolio against the effects of deflation and the compression of the yield curve. 

Extreme over-indebtedness has been dramatically worsened by multiple rounds of fiscal stimulus in response to the global pandemic.  Deflation may be the most challenging economic environment for investors. 

KraneShares Quadratic Deflation ETF (BNDD) is a fixed-income ETF that seeks to benefit from lower growth, deflation, lower or negative long-term interest rates, and/or a reduction in the spread between shorter and longer-term interest rates by investing in US Treasuries and options.

The BNDD portfolio is composed primarily of long-dated US treasury bonds.  In addition to bonds, the portfolio includes long-only options on the shape of the US interest rate curve.  As interest rates decline, the bonds should appreciate.  The options provide exposure to the spread between interest rates at different points in time.  As the curve flattens because of lower inflation expectations and/or deflation, the price of the options tends to increase. 

BNDD provides a unique access point to the OTC fixed-income options market, which is typically unavailable to investors directly.  The fund has the potential for enhanced returns in periods of lower growth while the options downside is limited to the market value of the options.  This strategy can serve as a bond enhancement strategy and works well as a complement to other diversifying investments.  Since its inception less than one year ago, BNDD has essentially matched the performance of the S&P 500 with a fraction of the risk.