Our Highest-Conviction Fixed Income Trade over the Next 2 Years

Our Highest-Conviction Fixed Income Trade over the Next 2 Years ETF WisdomTreeOur Highest-Conviction Fixed Income Trade over the Next 2 Years

On March 21, the Federal Open Market Committee voted to increase the Federal Funds Rate target for the sixth time since December 2015. As the Federal Reserve (Fed) continues to tighten policy, the ability to generate returns in short-dated fixed income has increased. In response, investors have piled nearly $6.7 billion over the last year into two exchange-traded funds (ETFs) that seek to track one- to three-month Treasury Bills. 1 While we agree with the shift to lower duration as long-term interest rates increase, the shift into t-bills is leaving a significant amount of return potential on the table. Below, we highlight the rationale for our highest-conviction fixed income trade over the next two years and why we believe investors should be investing in floating rate Treasuries instead of three-month t-bills.

Contrasting Two-Year Floating Rate Treasuries vs. 13-Week T-Bills

While t-bills and floating rate Treasuries are both issued by the U.S. government, the yield for a 13-week t-bill is set at a weekly auction. Instead of paying interest, they are generally auctioned at a discount to par, so when they are held to maturity, an investor’s holding period return would equal the quoted yield. Since they do not make intermediate coupon payments (like longer-tenor Treasury notes), the duration of the bill is equal to its maturity (13 weeks).

In January 2014, the U.S. Treasury issued its first floating rate note (FRN). Treasury FRNs pay a coupon on a quarterly basis and mature in two years. The coupon rate “floats” and is based on the 13-week t-bill yield plus a spread. The spread represents a snapshot of demand for a particular FRN when it is auctioned and remains fixed for the life of the note (low demand = high spread; high demand = low spread). The duration of the FRN is only one week because that is the amount of time between interest rate resets.

Trade Rationale

The simple reason that we prefer floating rate notes versus rolling three-month t-bills over the next two years is that we want to receive higher yields as the Fed hikes rates. As short-term interest rates rise, the yield on Treasury floaters will reset each week at progressively higher rates. By contrast, if investors wanted to roll three-month t-bills over the next two years, they would only able to boost the yield of their holdings every three months (e.g., four times per year). Additionally, FRNs receive a spread over three-month t-bills, which currently boosts yields by 5 basis points (bps).

Cumulative Performance

Given that the Fed started hiking rates in December 2015, we know that owning FRNs whose coupons reset along with increases in t-bill yields was the right trade. As we show in the chart below, investors could have generated 1.08% more return by owning FRNs rather than t-bills. Put another way, investors could have nearly doubled their returns by bearing the risk that yields might have declined during these more regular auctions.

Cumulative Return: 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.

1 Source: Bloomberg, from 3/26/17 through 3/26/18.
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Important Risks Related to this Article

There are risks associated with investing, including possible loss of principal. Securities with floating rates can be less sensitive to interest rate changes than securities with fixed interest rates but may decline in value. The issuance of floating rate notes by the U.S. Treasury is new, and the amount of supply will be limited. Fixed income securities will normally decline in value as interest rates rise. The value of an investment in the Fund may change quickly and without warning in response to issuer or counterparty defaults and changes in the credit ratings of the Fund’s portfolio investments. Due to the investment strategy of this Fund, it may make higher capital gain distributions than other ETFs. Please read the Fund’s prospectus for specific details regarding the Fund’s risk profile.

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If Bank of England doesn’t hike rates in 2017, then when?

If Bank of England doesn’t hike rates in 2017, then when?

One year on from the last rate cut, the Bank of England has kept rates on hold, with the MPC voting 6-2 in favour of the decision (roughly the same as last month). Although policy remains unchanged, GBP should remain supported by what is expected to be a tighter policy path in 20-17/2018. Indeed, Governor Carney indicated that policy may need to be tightened at a faster rate than the market is currently pricing. If Bank of England doesn’t hike rates in 2017, then when?

While a decidedly cautious tone was struck by Governor Carney at the Bank of England press conference, tighter policy is coming: if UK economic growth continues at the rate the BOE has forecast, the market is underpricing the amount of policy tightening that is necessary.

The UK economy remains relatively resilient after the EU Referendum, with the unemployment rate at pre-crisis levels and evidence that both the manufacturing and services sector are growing in a robust manner. The reason for the additional Bank of England stimulus (a rate cut and additional asset purchases) a year ago was necessarily forward looking: ‘the weaker medium-term outlook for activity…[will lead to] an eventual rise in unemployment. The central bank seems to have become less proactive since then, highlighting that the UK is currently ‘in the teeth’ of the squeeze for households and both consumption growth and business investment will improve further in coming months.

The inflation remains elevated in the UK

Meanwhile, inflation remains elevated in the UK and well above the BOE’s target. The longer this continues, the greater the chance of expectations becoming unanchored, especially if energy prices rise again. While inflation hasn’t surprised to the upside in recent months, market implied inflationary expectations remain elevated (well above a year ago), and above other major economies.

(Click to enlarge)

Current BOE Policy remains extremely accommodative

Current BOE Policy remains extremely accommodative. There may be uncertainties around the Brexit negotiations, but emergency interest rate settings do not seem appropriate. Indeed, Governor Carney notes that there are limits to what monetary policy can do relating to the Brexit situation. We expect that negotiations surrounding Brexit will remain in flux and that given there is unlikely to be significant progress made, the worst case scenario has already been digested by the market and GBP. In turn, the BOE is likely to unwind their Brexit induced rate cut from last year in H2 2017.

The key sentence in the BOE’s Monetary Policy Summary report is ‘The combination of high rates of profitability, especially in the export sector, the low cost of capital and limited spare capacity supports investment by UK firms over the forecast period, offsetting the effect of continued uncertainties around Brexit’. Surely if the economic uncertainty surrounding Brexit is offset, then the 2016 rate cut and additional stimulus should be unwound…if not in 2017, then when?

 

Martin Arnold, Global FX & Commodity Strategist at ETF Securities

Martin Arnold joined ETF Securities as a research analyst in 2009 and was promoted to Global FX & Commodity Strategist in 2014. Martin has a wealth of experience in strategy and economics with his most recent role formulating an FX strategy at an independent research consultancy. Martin has a strong background in macroeconomics and financial analysis – gained both at the Reserve Bank of Australia and in the private commercial banking sector – and experience covering a range of asset classes including equities and bonds. Martin holds a Bachelor of Economics from the University of New South Wales (Australia), a Master of Commerce from the University of Wollongong (Australia) and attained a Graduate Diploma of Applied Finance and Investment from the Securities Institute of Australia.