Last week, the Federal Reserve raised interest rates for the third time this year, prompting fixed income market participants to speculate a fourth rate hike will arrive in December and that the Fed will again raise rates multiple times next year.
Floating rate notes (FRNs) have been popular destinations this year for fixed income investors amid Fed tightening. One of the fastest-growing exchange traded funds this year in the FRN category is the WisdomTree Bloomberg Floating Rate Treasury Fund (NYSEArca: USFR). USFR, which debuted in February 2014, follows the Bloomberg U.S. Treasury Floating Rate Bond Index. The fund’s holdings are priced at a spread over 3-month Treasury bills. Floating rate notes featured in USFR mature in 2019 and 2020.
The current environment is conducive to FRN strategies.
“Against this backdrop, fixed income investors will more than likely continue to search for rate-hedging solutions. One approach investors tend to implement involves U.S. Treasury (UST) Inflation-Protected Securities, or TIPS,” said WisdomTree in a recent note.
A Low Risk Proposition
Looking ahead, the floating rate notes will generate more interest if Treasury prices fall and yields rise further, which should play out if the Fed continues on its interest rate normalization schedule.
TIPS are a type of Treasury security that are indexed to inflation as a way to shield investors from the negative effects of inflation. The securities’ par value rises with inflation as measured by the Consumer Price Index while interest rate remains fixed. TIPS also offer investors another layer of diversification as many aggregate bond funds exclude TIPS from their holdings.
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Floaters have some advantages of TIPS. Floating rate note coupon payments are based on a reference rate (90-day t-bills) plus a spread. Since 90-day bills are auctioned every week, the effective duration of floating rate notes is one week, which allows investors to capture higher rates of income as short-term rates rise. This also provides an opportunity for investors to boost income as the Federal Reserve hikes interest rates.
“FRNs are more directly tied to changes in interest rates, specifically Fed rate moves, while TIPS are more directly tied to changes in inflation. These two factors don’t always move in tandem, with 2017 being a perfect example. To illustrate, last year, the Fed raised rates three times (75 basis points [bps]) while CPI finished 2017 at a year-over-year rate of +2.1%, identical to the 2016 pace,” according to WisdomTree.
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