Supply And Demand
Supply and demand concerns are also an important consideration.
In the short term, the introduction of high-quality floating-rate bonds may cause some selling pressure in the investment-grade corporate floating-rate market and the senior leveraged loan market. The risk of short-term pressure may come from investors reallocating existing exposure to floating-rate bonds issued by the Treasury.
Because the Treasury doesn’t issue the bonds currently, investors seeking the benefits of floating rate are steered in the direction of the existing floating-rate ETFs mentioned earlier.
All of these options are expected to generate default levels greater than those of Treasurys. So owning floating-rate bonds currently comes with the assumption of additional default risk.
But when the Treasury issues the first floating-rate note, this link will be severed. With the additional supply, investors may diversify their holdings, putting pressure on existing floating-rate positions.
The likelihood of such pressure will partly depend on the yield of the new Treasury floating-rate bonds.
Credit spreads of existing corporations and Treasurys suggest the new bonds will yield around 0.25 percent. Here’s why:
- Intermediate corporate bonds have a yield around 2 percentage points—or 200 basis points—greater than the Treasurys of a similar duration.
- Corporate bonds with a duration of one to three years yield about 1 percent more than similar maturing Treasurys.
- iShares FLOT only yields approximately 0.50 percent.
- It doesn’t make sense for the new floating-rate Treasurys to have a negative yield, so scaling down the yield difference even further produces a yield of 0.25 percent.
One aspect we will be watching is whether the market puts a liquidity premium on floating-rate Treasurys.
When TIPS were launched a number of years ago, there seemed to be a liquidity premium over regular Treasurys that slowly wore away with greater market acceptance of the securities.
The degree of a premium should be restrained considerably by having investment-grade bonds anchoring expectations. Even with a slight liquidity premium, floating-rate Treasurys should yield less than FLOT. However, there may be some attractive spread opportunities by selling nominal Treasurys and FLOT, and buying floating-rate Treasurys and nominal corporate bonds.
The market for floating rate is certainly getting, and deserves, more attention than it did in the past.
Having floating-rate bonds all along the risk spectrum will also expand the tactical opportunities open for assembling and reassembling bond portfolios based on all sorts of characteristics.
CLS Investments is an Omaha, Neb.-based third-party investment manager and ETF strategist. CLS began to emphasize ETFs in individual investor portfolios in 2002, and is now one of the largest active money managers using exchange-traded funds, with more than $2 billion invested. Contact Scott Kubie at 402-896-7406 or at [email protected].