‘FLOT’: When An ETF Discount Is Good

December 11, 2018

As a kid, I loved the tales of Uncle Remus, where Br’er Rabbit always outsmarts Br’er Fox, famously convincing the Fox to throw him into the “briar patch”—his natural home.

Last week’s trading in the iShares Floating Rate Bond ETF (FLOT) reminded me a lot of that: a lot of brouhaha that ultimately just proved where FLOT really belongs.

What’s really going on? Let’s get into the briars:

First, let’s take a look at the chart that’s causing all the Twitter Chicken Little Sky Is Falling:

 

 

This plots the trading price of FLOT versus its end-of-day net asset value (NAV). A few things to note here. First, it historically trades at a slight premium. There are actually three independent reasons for this.

  • FLOT has received pretty steady inflows all year long ($5.4 billion in new assets for the now $12 billion fund). Absent any other information, inflows mean you’d expect slight premiums in any ETF because it takes a little bit of buying pressure to push the price of an ETF over fair value. That’s what triggers the authorized participant community to do a creation, which we see as positive flows.
  • As a bond fund, I suspect that the NAV is calculated on the bid. In other words, the price of each holding at the end of the day is determined by the fund accountant as “what can I sell this bond for?” Since the trading price of the ETF (especially if there’s positive flows) is based on actual activity, its closing price is much more likely to be at the midpoint of bids and asks, or at the “asks.” This created a “natural” perceived premium in almost all bond funds, all else being equal.
  • FLOT owns illiquid securities, for which pricing is, at best, a guess.

Flow, Pricing & Underlying

The same three issues: Flows, pricing and underlying are potentially involved in understanding the trading of FLOT last week.

Let’s dive into this last point. By design, FLOT tracks an index made up of floating-rate bonds with maturities from one month to five years.

These aren’t the same as bank loans—another kind of floating-rate security generally issued by the junkiest of the junky issuers. These are primarily bonds rated “A” and above, issued by banks and some other giant conglomerates and international companies.

These floaters represent a very small portion of most companies’ debt, and can—optimistically—be said to trade by appointment. They are in demand by long-term holders (think big institutions) precisely because they offer some protection from rate increases.

But if you’re a big insurance company sitting on a position, you’re not likely to trade it out. You’re likely to just hold it until it matures in a few years.

Consider the trading activity in FLOT’s biggest holding, a Morgan Stanley floater that comes due in 2020:

 

 

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