Last year, markets evolved from the reflation trade to the inflation trade, and, as experienced investors know, inflationary pressures usually result in central bank tightening of interest rates.
With inflation running at its highest levels in nearly four decades and proving much more persistent than initially expected, it’s seemingly a foregone conclusion that the Federal Reserve will raise interest rates this year, perhaps multiple times.
Fixed income investors have some avenues for combating higher interest rates, including floating rate notes. A variety of exchange traded funds, including the WisdomTree Bloomberg Floating Rate Treasury Fund (NYSEArca: USFR), provide exposure to that corner of the bond market. USFR, which turns eight years old next month, tracks the Bloomberg U.S. Treasury Floating Rate Bond Index.
Kevin Flanagan, WisdomTree head of fixed income strategy, highlights recent action in two-, five- and 10-year Treasury yields as possible signs that investors might want to evaluate rate-hedge strategies and funds such as USFR.
“If you look closely, you’ll see that, although yields have increased rather noticeably, the Treasury yield curve, as measured by 2s versus 10s, has actually remained the same,” Flanagan says. “In other words, after a sawtooth pattern to the upside for the UST 10-Year yield, the UST 2-Year note has now caught up and registered an identical rate increase over the last 12 months. The increase of nearly 90 bps in the UST 5-Year note definitely stands out and underscores the reason why rates are poised to move higher from their current levels.”
When yields rise, it’s a particularly thorny issue for longer-dated bonds. Conversely, floating-rate bonds, including USFR components, significantly reduce rate risk. In the case of the $1.84 billion USFR, the fund’s effective duration is just 0.02 years, according to issuer data.
USFR could be an exchange traded fund for bond investors to lean on this year because it’s possible that the Fed goes beyond three rate hikes, particularly if inflation doesn’t cool.
“The policy makers will be very data-dependent on this front, and if you believe, like we do, that inflation will remain stubbornly high, you may want to take the ‘over’ on those three rate hikes, not the ‘under.’ At this point, I believe Powell & Co. will maintain a deliberate approach, but that could change based on future inflation numbers,” adds Flanagan.
Plus, USFR could be a better bet in 2022 than short-term Treasuries and Treasury Inflation Protected Securities (TIPS).
“UST 1–3-Year yields are susceptible to Fed rate hikes, while 10-Year TIPS, or real yields, are not immune to periods of rising rates either,” concludes Flanagan.
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The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.