Let's Rewind

2022 and 2023 were hectic - war, bank crises, and bear markets.

Inflation was still running rampant - with the core PCE having just peaked at +6.4% in February 2022. These consistent out-of-control inflation reports caused the Federal Reserve to take action by doing the only thing they know how to do - raise interest rates.

Starting in March 2022, the Fed raised rates at the fastest speed in modern history - from essentially 0% to 4.75% in only 12 months. As you can imagine, this rapid increase in interest rates caused bond prices to go into a free fall.

For those of you unaware, bond prices move inversely with interest rates.

Think about it like this - if you're an investor looking to generate fixed income inside of your portfolio, buying bonds might seem like a good idea.

However, as the months tick by and interest rates continue to rise, the value of the older bonds begins to fall - who wants to own a bond paying 3% ... if you can own a bond paying 5%.

Now, after nearly two years of consistent interest rate hikes, it seems like the Federal Reserve might be taking a break - at least that's what the market is hoping for.

Since mid-October, the price of the iShares 7-10 Year Treasury Bond ETF (NASDAQ:IEF) has begun to make a comeback, having traded up +8.9%. With inflation now showing consistent contraction, the market is not only pricing in a Federal Reserve "pause," but also interest rate cuts in 2024.

Fast Forward

Looking ahead to 2024 and 2025 - investors believe there are several reasons to be excited about adding core aggregate bond exposure to their portfolios. Bonds help provide stability in a multi-asset portfolio - coupon payments generate income, and bond prices tend to rise when economic growth slows.

Considering the slowing economic climate and current interest rates, bonds might be able to deliver on both of those fronts in 2024.

Aross many sectors of the bond market, yields have reached highs not seen since 2007. For example, the yield on a 5-year Treasury Bond is +241 bps above the dividend yield of the S&P 500 (NYSE:SPY) at the moment. The only negative yielding debt left in the entire world is in Japan.

I think strong performance will begin in 2024. We could experience modest price appreciation as yields fall while paired with a very attractive bond yield. Economic growth should continue to slow, inflation will continue to cool, and central banks will begin to reverse their rate-hiking cycles.

Choosing bonds within the 3-10 year maturity range offers investors an attractive yield while being less exposed to longer-term risks regarding government deficits.

My Personal Choice

The Neos Enhanced Income Aggregate Bond ETF (NYSE:BNDI) allows me to capture 2-2.5% more income per year while adding negligible risk to my well-diversified portfolio.

According to the prospectus, the Neos Enhanced Income Aggregate Bond ETF seeks to achieve its investment objective of generating monthly income in a tax-efficient manner by...

"(i) Investing 80% or more of its assets in bonds or ETFs that ... obtain exposure to the performance of the US Aggregate Bond market and (ii) selling and purchasing S&P 500 Index put options to generate income to the Fund beyond what is received from the Underlying Investments."

The prospectus also clearly states their intention to hold US Treasury bonds, government-related bonds, corporate bonds, mortgage-backed pass-through securities, commercial mortgage-backed securities and asset-backed securities to obtain exposure to the US Aggregate Bond market.

After looking at their holdings (as of 12/27/23), I've confirmed this is the case - as the vast majority of the Fund's assets are invested evenly between the Vanguard Total Bond Market Index Fund ETF (BND), and the iShares Core US Aggregate Bond ETF (AGG).

Their holdings also show us that their fund managers are buying put options on the S&P 500 Index with a strike price about 9.5% below the current price of the S&P 500 Index (4,781 at the time of writing) - while simultaneously selling put option contracts about 5.5% below the current price of the S&P 500 Index.

It's important to note that these put option contracts have expiration dates roughly two weeks out from the time of purchase.

Year-to-date, BNDI has paid $2.52 per share to their investors. This $2.52 figure roughly equates to the 5.53% distribution yield shown here on their website.

When taking into consideration the forward dividend yield of the underlying investments inside of BNDI as shared earlier - the fund managers are generating +239 bps of additional yield on top of the already 3.14% yield produced by the fund's underlying investments.

They're doing this while taking on negligible risk, as shown on this page of their website.

If you compare Scenario 1: Hypothetical core asset allocation's portfolio yield and 1-yr standard deviation to Scenario 3's - you'll see that when you replace traditional fixed income securities with BNDI the portfolio's overall yield increased dramatically while 1-yr standard deviations remains nearly the same.

That's the secret sauce here with BNDI - when owned inside of a well-diversified portfolio, investors can expect heightened portfolio yield with near-identical risk.

Risks

As with all investment ideas, this one doesn't come without its risks. In my opinion, there are two main risk factors at play here - the Fed not cutting rates in 2024 and BNDI's put option strategy.

According to a recent report shared with JPMorgan's private banking clients, Wall Street is assuming a +12% increase in bond prices per -1% cut in interest rates. Of course, these are all assumptions and nothing is guaranteed.

If the Fed does not cut interest rates in 2024 and instead holds steady throughout the year, BNDI would likely trade sideways - forcing investors to depend on the Fund's put option strategy and the existing yield of its underlying investments to generate returns for their portfolios.

If you're an income-focused investor, this outcome might not be a bad scenario for you. If you're looking for both price appreciation and yield, this outcome would be disappointing.

The second risk factor is their put option strategy - leaving the fund to be on the hook for paying out against the option contracts they've sold. Considering the Fund managers' backgrounds in options-based ETFs, this is something I'm not worried about. This is the same leadership team successfully executing upon both the (SPYI) and (CSHI) ETFs - one of the main reasons I'm interested in this "hidden gem" ETF in the first place.

Statistically speaking, this put option strategy going sour would be a Black Swan event of sorts. To learn more about this put option strategy, feel free to read this analysis on CSHI which uses a similar, but slightly more conservative, strategy.

In Summary

2022 and 2023 were quite hectic for the bond market as investors were forced to continually discount the price of bonds to offset increasing interest rates. However, 2024 is shaping up to be a year that could catalyze both price appreciation while locking in heightened rates.

The Neos Enhanced Income Aggregate Bond ETF is how I plan to play this move - not only will I be experiencing possible price appreciation given their fund's underlying assets with heightened rates, but I'll also be earning +2.2% more in income given their put option strategy while taking on very little additional risk.

This article is from an external contributor. It does not represent Benzinga's reporting and has not been edited for content or accuracy.

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Thursday, January 04, 2024