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Barely more than halfway through 2022, it’s clear this is turning out to be a treacherous year for fixed income investors. The Bloomberg US Aggregate Bond Index is lower by more than 10%.
That certainly paints the picture of woe in the bond market. The widely-observed Bloomberg US Aggregate Bond Index is home to nearly 10,300 bonds, meaning it is indeed broad and an accurate representation of bond market duress.
Those are the breaks when the Federal Reserve raised rates three times, amounting to an increase of 1.5%, in the first six half of the year and with more to come, it’s understandable that advisors and clients alike are fretting about what’s to come for fixed income returns.
Fortunately, the fixed income universe isn’t entirely bereft of segments worth examining today. Upon closer examination, there are bond assets that are surviving and thriving this year. Predictably, many of those assets have track records of durability against the backdrops of rising interest rates and persistent inflation. As has been previously noted, floating rate notes (FRNs) are part of this conversation.
Focusing on Floaters
Owing to the fact that FRN coupons reflect current interest rates, the prices of these bonds aren't overly sensitive to interest rates.
Among exchange traded funds, advisors have plenty of choices for FRN exposure, but for the purposes of this piece, I’m focusing on the WisdomTree U.S. Floating Rate Treasury Fund (USFR). To its credit, USFR is sporting a modest year-to-date gain and it appears advisors are taking note as highlighted by 2022 inflows of $4.2 billion – a significant percentage of its $7.55 billion in total assets under management.
With FRNs and a fund such as USFR, the “second component comes from a spread (positive or negative) that represents the amount of demand for FRNs when they are initially auctioned every quarter,” notes Bradley Krom, head of U.S. research at WisdomTree. “In an average-to-low-demand environment, the spread is positive, so investors receive rates above 90-day T-bill yields. When demand is high, this spread may be zero or even negative, like we saw at the U.S. FRN auctions on January 31 (-0. 015%) or May 2 (-0.075%).”
USFR remains relevant today because FRNs are at their best when rates and more of that is likely in store as bond markets are pricing in rate increases equivalent to another 200 basis points before the end of 2022.
“Since the U.S. government borrows money for as little as four weeks and as long as 30 years, we are able to observe the potential future path of U.S. 3m Treasury bills based on expectations about Fed rate hikes,” adds Krom. “Based on current expectations, 3m Treasury bills are currently forecast to return 1.63% through the end of 2022. If the Fed doesn’t hike as aggressively, returns will likely be lower than today’s expectations.”
Precedent Matters
Past performance isn’t a guarantee of future returns. However, USFR is more than eight years old, so it’s been around for a few cycles of rising Treasury yields.
From 2016 through 2021, USFR beat 3-month T-bills on annual basis on three occasions and tied in another year.
“While these returns are far from guaranteed, they represent the market’s best estimate of what might be in store for fixed income investors for the remainder of 2022. With high levels of uncertainty in other markets, we think USFR could offer a compelling case for returns as the market continues to grapple with high inflation and bouts of volatility,” concludes Krom.
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