Cumulative Return: U.S. FRN vs. 1-3m T-Bills
U.S. FRN vs. 1-3m T-Bills
Similarly, we can also see that this strategy really tends to outperform when the Fed hikes rates more aggressively. During periods where the Fed is not raising rates, the performance advantage for FRNs is driven by the positive spread. While the Fed’s previous projections called for three rate hikes in 2018, it now seems like four rates hikes may be necessary. As a result, the case for owning FRNs only increases in this scenario, in our view.
Contrasting Yield and Calendar Yield Returns
A common rule of thumb for fixed income investments is that the starting yield is the best determinant of total return. For FRNs, this will tend to understate the total returns when the Fed is hiking rates and overstate total return potential when the Fed is cutting rates.
As we show below, floating rate notes outperformed in every year that the Fed tightened policy, with the exception of 2015.
FRNs and t-bills experienced similar performance in 2015 because the rate hike occurred in December and bill yields actually fell below zero from September through October as investors fretted over the government debt ceiling impasse. In 2016, the rate hike also occurred in December, but bill yields generally trended higher over the course of the year, thus rewarding FRNs with higher carry.
In our view, 2017 may be the most instructive test case for investors in 2018. With a fairly well telegraphed policy of rate hikes in place, the Fed hiked rates in March, June and December. This resulted in FRNs outperforming t-bills by approximately 40 bps.
In our view, should this occur again in 2018, we believe a 40 bps return advantage is reasonable. Should the Fed ultimately hike rates four times in 2018, we believe this return advantage could increase. With most fixed income investors seeing bond portfolios decline in value as longer tenor rates have risen year-to-date, we believe FRNs strike an attractive balance between income, volatility and minimal downside risk. Should rates follow a similar path to 2017, stable and low volatility returns in excess of 2% should be possible.
Impact of Fed Policy on U.S. 1-3m T-Bill & FRN Returns
Given that the basis of our view on FRNs over t-bills is based on what we see as the likely path of Fed policy, this trade represents our highest-conviction fixed income trade of 2018. Similarly, it also represents one of the lowest-risk trades investors can make this year.
While a more hawkish Fed will increase the return differential, this approach loses out to t-bills if the Fed ends its tightening bias or t-bill yields decline based on some sort of political shock. With all these risks considered, we believe investors should consider the WisdomTree Bloomberg Floating Rate Treasury Fund (USFR) as our high-conviction trade for rising rates.