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.
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].