Daily Stock Pick: March 9th, 2023

Stocks ticked lower this morning on the heels of Fed Chair Powell’s hawkish comments yesterday. Market participants are now bracing for larger-than-expected rate hikes for longer than previously anticipated.  

While all attention is focused on inflation, recession cycles come with a more substantial risk for deflation. Today we’re focusing on 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. 

Deflation may be the most challenging economic environment for investors yet. 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 in price. 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 OTC fixed-income options market, which is typically not available 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.