Being Fond of Floaters Could Work in Tricky Fixed Income Environment

Multiple corners of the bond market are under duress this year, crimping conservative, income-seeking investors. One way to cope with that scenario could be with floating rate notes (FRNs), an asset class accessible via 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, like the name suggests, have a floating interest rate. Specifically, the notes’ have a so-called reset period with interest rates tied to a benchmark, such as the Fed funds, LIBOR, prime rate, or U.S. Treasury bill rate. Due to their short reset periods, these floating rate funds have relatively low rate risk.

Recently volatility in the corporate bond market, even among investment-grade issues, highlights the utility of USFR in today’s climate.

“The market dislocations created by the coronavirus and the dissolution of the OPEC+ alliance were swift and pronounced,” said WisdomTree in a recent note. “The losses in corporate bonds—both investment- grade and high- yield—in the two-week period from March 9 to March 23 were the worst on record (using returns dating back to 1998). While the corporate market was the epicenter, no fixed income market emerged unscathed, as many safe haven assets like U.S. Treasuries failed to offer relief during the period.”

Understanding USFR

USFR uses a“rules-based approach and re-weights the subcomponents of the Bloomberg Barclays U.S. Aggregate Bond Index to enhance yield, while broadly maintaining familiar risk characteristics. AGGY tries to boost return by reweighting the components of the Aggregate Index. But this additional yield is not free as it comes with greater credit risk and rate risk,” according to WisdomTree.

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 if the Federal Reserve hikes interest rates, though that’s unlikely to happen anytime soon.

“Market structure came under attack and the Federal Reserve (Fed) quickly responded with an unprecedented quantitative stimulus, providing support to nearly every corner of the fixed income market,” notes WisdomTree. “The monetary infusion seeks to preserve and facilitate the inner workings of the global funding markets, while the fiscal injection is the necessary driver to support the U.S. economy. Although there are likely to be additional setbacks, indiscriminate selling in many sectors has created long-term opportunities, particularly given continued strong support from the Fed and well-capitalized financial institutions.”

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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.