Market conditions creating a ‘trap for credit investors,’ Simplify ETF CEO says

Paul Kim, Simplify ETF CEO discusses how inflation could potentially create economic risks across markets and details his thoughts on the risk of a recession.

Video Transcript

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- Well, inflation is showing some signs of cooling, with the PCE price index increasing only a tenth of a percent in March compared to 3/10 of a percent in February. But the annual increase in prices at 4.2% is still more than dabble-- double, rather, what the Fed wants it to be.

Joining us now is Paul Kim, Simplify ETF CEO. Paul, thanks so much for joining us. Let's get right into this conversation. What are you advising clients about how to handle their portfolio in this kind of environment?

PAUL KIM: Well, thanks-- first, thanks for having me on. It's a great time here. I've always enjoyed my previous showings on Yahoo. Our base case is kind of more of the same, which is a choppy, sort of stagflationary environment, stagflation meaning inflation remains elevated but, yes, you're going to see sort of ups and downs, especially as things like energy prices go up and down.

So inflation's kind of elevated, remains sticky, which really means that the Fed is likely to sort of keep rates higher. Even if there is a pause, I think we could expect volatility in the interest rate market and elevated interest rates. So in that market, I think a really-- a good exposure to have would be something that does well in kind of a sideways choppy market.

On the equity side, we've seen a lot of interest in things like covered call strategies, right, not our ETF, but JP Morgan's JEPI-- J-E-P-I-- is a great example of a actively managed fund that's done well, giving up some upside but collecting a lot of option income.

Two of our strategies, I think, that are kind of similar, we have a hedged equity strategy, which has a cost is color. You give up a little bit of your upside and you get a lot of downside protection, HEQT. Another one is a sort of volatility selling ETF called SVOL-- S-V-O-L-- and that's delivered about a 17% distribution yield. So a sideways market creates some opportunities.

On the fixed income side, we've been seeing a return of flows back into fixed income. Higher rates mean more income. And for investors with a healthy fixed income allocation, I think they've really seen the benefit of higher rates.

On the other hand, while 2022 was all about duration risk, I think this year it's all about credit risk. And we're looking at a very sort of a tougher environment ahead. Credit is tightening. Growth is slowing. Inflation remains elevated. That's a classic sort of trap for credit investors.

JULIE HYMAN: Well, so, Paul--

PAUL KIM: So we've been sort of looking at that.

JULIE HYMAN: Well, Paul, I've heard a lot of people talk about these potential risks in credit.

PAUL KIM: Yep.

JULIE HYMAN: Sort of paint a picture for me how exactly that could play out. Where are the risks going to be? Are we talking about economic risks? Are we talking about investment risks for people who are in, say, high yield, for example? How is that going to manifest itself?

PAUL KIM: So I think you're starting to see it in the data, which is basically higher defaults, right? So you're seeing it, ironically, in the high-quality financial names, but you're also seeing it in sort of zombie business models that worked really well for decades at low or zero interest rates and now have to think about refinancing risk as rates in high yield are 6%, 7%, 8% or higher. That really impacts business models and profitability.

And while not everyone has to refinance this year, you're starting to see that and look ahead and see that sort of challenge. And you're also seeing it in things like commercial real estate. So there's different sectors that are very interest rate sensitive, and particularly refinancing risk sensitivity.

- Paul, I got to ask you, so speaking of risks, there remains the risk of recession this year. What's your view on how people should prepare themselves with that potentially happening?

PAUL KIM: Up in quality, things like treasuries, things like option income that sort of lets you sidestep a lot of the credit risk. I think basically, this market is giving a chance for all investors to really up the quality and defensive posture of portfolios and think about absolute return strategies, alternatives.

It's a great entry point for a lot of other asset classes. And then there's always fixed income. T-bills are still giving you 3% to 4% returns, and it's a pretty safe spot to sit out and avoid equity and credit market volatility and wait for that sort of fatter pitch on eventually the recession getting priced in.

JULIE HYMAN: And what about other sort of kinds of alternatives, if you will, here in this market outside of equities and fixed income? What specifically are you looking at?

PAUL KIM: We're looking at commodities. But you don't want to be just passively long a basket. I think different parts of the commodity market will react differently to inflationary concerns versus the recessionary concerns. So something like a gold, right, gold allocation behaves very differently from oil, which is much more tied to the economic cycle.

And so our approach would be to invest in things like managed futures that can take a very nuanced view on the different commodities out there, be long certain commodities, short others. And it also has a side benefit of, again, not being wedded to a single beta. Commodities, in general, are selling off, but there are pockets of commodities that are doing really well. Managed futures are a great way to diversify a portfolio. We have a ticker CTA of an ETF that provides that, but there's also competitors as well as different commodity strategies.

- All right, Paul Kim, we'll have to put a pin in our conversation there. Paul Kim, Simplify ETF CEO, our thanks to you.