Kubie: All In On Treasury Floaters

December 20, 2013

The Treasury’s plan to issue floating-rate debt is a new addition to a useful class of debt, CLS’ Kubie says.

This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today’s article features Scott Kubie, chief investment strategist at Omaha, Neb.-based CLS Investments.

The floating-rate bond market is an attractive opportunity and CLS welcomes the recent Treasury decision to issue floating-rate bonds.

Over the intermediate term, floating-rate bonds represent attractive investments because they are less sensitive to changes in interest rates.

And it goes without saying that interest rates are likely to increase as long as economic growth maintains its current level and the Federal Reserve withdraws its monthly asset purchases from the market.

Our favorite existing ETFs are the iShares Floating-Rate Bond ETF (FLOT | A-96), which targets the investment-grade corporate bond market, the PowerShares Senior Loan Portfolio (BKLN | B) and the SPDRs Blackstone/GSO Senior Loan ETF (SRLN). The history of these ETFs is relatively short. FLOT and BKLN both launched in the first half of 2011 and SRLN launched earlier this year.

The Treasury’s decision to issue floating-rate bonds should shake up an already-attractive bond segment by providing a “risk-free” Treasury option to match the existing ETFs in the investment-grade and bank credit segments. ETF providers sense the opportunity. State Street, Wisdom Tree and iShares have all filed for ETFs based on the yet-to-be-issued floating-rate Treasury bonds.

Stepping back for a moment, classifying the senior loan market seems to be a challenge for investors. Many investors seem to treat them as a little more risky than investment-grade bonds. CLS’ risk budget strategy desires a more precise answer.

Based on a multifaceted risk analysis, senior loan ETFs most resemble short-term high-yield bonds. For example, the volatility levels are similar. Over the past two years, the weekly standard deviation of BKLN and Pimco’s 0-5 Year High Yield Corporate Bond Index ETF (HYS | C-84) measured 2.45 and 2.76, respectively.

Interestingly, because credit markets have been tame, both of these values are less than intermediate Treasury ETFs over the same period.

A second measure reinforces the comparison to short-term high yield.

In 2008, the index behind HYS fell 19.73 percent, while the index used for BKLN dropped 28.18 percent. Short-term high yield and senior loans also exhibit similar equitylike characteristics. Both have beta scores of slightly more than 0.2, relative to the S&P 500.

Clearly, senior loans and short-term high-yield bonds exhibit similar risk characteristics.

So, which is more attractive: high yield or senior loans?

CLS is a fan of both, but we give the nod to senior loans for two reasons.

First, senior loans have gained a modest yield advantage. Beginning with their one-year anniversary in mid-2012, the rolling 12-month yield of HYS has consistently been above the yield of senior loans.

However, in August, senior loans gained a minor yield advantage, which they continue to hold. The yields of both securities have dropped over the period, but the short-term high yield has seen a more rapid decline in yield.

Second—and crucially—the duration of senior loans should be less sensitive to changes in rates.

Floating-rate investment-grade bonds also have advantages relative to nominal corporate bonds. The only challenge for FLOT is its yield. After all, for the protection of a floating-rate security, investors are accepting an approximate yield of 0.50 percent.

One way FLOT contributes to portfolios is by adding yield over cash investments for modest levels of additional risk. It can also contribute by lowering interest-rate risk. If rates rise moderately, then using FLOT tactically is likely to pay off. However, investors aren’t getting wealthy on such a low yield that’s below the rate of inflation.

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