In 2013, one of the hottest trends in the exchange-traded fund (ETF) industry centered on investors’ managing their exposure to interest rate risk. As part of this trend, investors reduced their positions in fixed-rate coupon bonds by buying floating rate notes and bank loans.1 By way of review, a floating rate note is a debt security whose coupon payments are reset periodically and pay a predetermined spread over a short-term interest rate such as the London Interbank Offered Rate (LIBOR), the Federal Funds Rate or a U.S. Treasury Bill Rate. As a result, investors’ compensation may rise or fall at each reset date as interest rates change. However, until today, ETF-minded investors’ only option for purchasing floating rate debt was limited to that issued by corporations. Even though we do not believe that credit conditions are likely to deteriorate overnight, we believe that investors should seek to balance the risks in their floating rate portfolios the same way they manage their more traditional fixed income portfolios between risky and credit risk-free securities.
New Issuance from Treasury
As we mentioned in a previous blog post, the United States Treasury completed its first floating rate Treasury auction on January 29, 2014, issuing $15 billion of a note with a two-year stated maturity.2 We believe this first issuance may represent an interesting new source of funding for the U.S. government going forward. As virtually all borrowers have sought to take advantage of interest rates near all-time lows, the overall maturity profile of their debt has tended to increase.3 The U.S. government’s issuance profile is no different. However, in order to diversify the sources of funding away from longer-dated debt and short-term Treasury bills, the Treasury sought to tap the growing demand from investors for floating rate debt as one more way to finance the government.
With interest rate risk on the minds of many investors so far in 2014, we believe that floating rate Treasury securities represent an effective way for investors to help reduce their exposure to rising interest rates while generating income payments that are backed by the full faith and credit of the U.S. government. Although returns in many markets such as bank loans have been impressive thus far,4 these markets may pose several risks that investors must thoroughly consider.
Replacing One Risk Factor with Another
In many investors’ minds, interest rate risk represents the primary risk to the performance of their bond portfolio. However, this can be an oversimplification when lending to issuers that have non-investment-grade credit profiles. Although we do not believe that credit conditions in the U.S. are about to change course, we do believe that investors should take a prudent approach to the market. The simple fact is that as money has continued to flood into the bank loan market, several risks have come to light.
Principally, with so many investors seeking out many of the same opportunities, there may be a risk that the market could be painted with too broad a brush. Not all borrowers are created equal, and with so much money flowing into the market, it is likely that many companies are enjoying more attractive borrowing rates than their fundamentals may warrant. As a way to mitigate credit risk, investors might consider diversifying their floating rate portfolio with a portion in U.S. government-issued floating rate debt.