Fixed income investors don’t lack choices when choosing funds to enhance their portfolios. The recent mutual fund conversion, the NEOS Enhanced Income Credit Select ETF (HYBI), offers notable yields and volatility reduction.
Garrett Paolella, co-founder and co-PM at NEOS Investments, recently appeared on Armchair Income to discuss HYBI. “Investors would really look at this for lower volatility and less correlation to where this would be an allocation into their fixed income side of their portfolio,” he said.
HYBI initially began as a mutual fund and generated notable performance in 2022 when stocks and bonds both declined. Paolella explained that while the Bloomberg High Yield Index fell more than 11%, the WSTCM Credit Select Risk-Managed Fund (mutual fund) only declined 2.3%.
The ETF earns income for investors in two fundamental ways: through its underlying bonds and the options overlay. This overlay seeks to provide an additional 2–2.5% of tax-efficient income. The fund offers a distribution rate of 8.74% as of October 31, 2024. Distribution rate annualizes the most recent distribution and divides by the fund’s NAV.
It’s also a “fund of funds,” or an ETF that gains exposure to underlying assets by investing in other ETFs. By investing in high yield corporate bonds ETFs, HYBI reduces potential liquidity risk compared to direct investment.
A Quantitative Approach to Bond Investing
“Our thesis has always been…quantitative strategies,” Paolella explained. “This is a quantitative model — it’s rules-based, so it’s not an individual portfolio manager selecting the ultimate positions and when we de-risk.”
HYBI’s quantitative model considers price trend within high yield bonds, credit spreads, and relative strength compared to the benchmark. Using these three indicators, the strategy determines its risk exposure, with the ability to invest in high-yield, investment-grade bonds, and short-term Treasuries.
In a declining rate environment, bond yields generally fall while their prices climb (bond prices and yields move inversely to each other). While bonds would generate less yields and income, they’d appreciate in price. Paolella doesn’t anticipate sharp swings in income for investors month-to-month, given the portfolio’s average duration of over four years as of the end of October.
An Options Overlay to Boost Potential Yields
HYBI augments income generated from its bond exposures with an options overlay strategy utilizing put spreads on the S&P 500 Index. By combining equity options with bond exposures, HYBI brings an institutional investment strategy to a broader audience
“We’re writing those put spreads an average of five to eight percent out-of-the-money, and we ladder them,” said Paolella. An out-of-the-money option is one in which the underlying asset price has not crossed the option’s strike price. Out-of-the-money options carry no intrinsic value. A ladder entails buying multiple option positions with a variety of strike prices.
In action, this means NEOS may sell a put with a strike price 5% below the current market price and then use some of the premium earned to buy a put at 8% below the current price. In doing so, it narrows the spread risk to the window between the 5% and 8% put positions. The options are also ultra-short in duration and rebalance weekly.
“This allows the overall options portfolio to…match the same standard deviation — or risk — that the fixed income is,” Paolella elaborated.
The fund uses index options, which are taxed favorably as Section 1256 Contracts under IRS rules. Options held at year’s end are treated as if sold at fair market value on the last market day. Any capital gains or losses are taxed as 60% long-term and 40% short-term, no matter how long investors hold them. This can offer noteworthy tax advantages.
The fund’s managers engage in tax-loss harvesting opportunities throughout the year on the options, as well as the bond allocations. HYBI carries a net expense ratio of 0.68%.
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