Thesis
The iShares Floating Rate Bond ETF (BATS:FLOT) is a short term bond fund which we have covered before here, where we were highlighting the reasons for which the name was a strong hold candidate for an investor’s spare cash. The vehicle has continued to deliver since we last visited the name around eight months ago:
The market has been fixated on the Fed in 2024 and its potential trajectory for rate reductions. Starting the year with six implied cuts in Fed Funds, the market is now down to one only, in the second half of the year. A ‘higher for longer’ rates environment translates into the front end of the yield curve providing for a high yield for the foreseeable future. Many participants were quick to unload floating rate assets in the beginning of the year, fearing an imminent rate cut, as early as March 2024 per some market forecasts. Those cuts never materialized with the data coming in stronger than expected.
In this article we are going to highlight why FLOT warrants a rating upgrade to ‘Buy’ given its very low volatility and ability to correctly capture the higher for longer rates environment.
Powell pushes back rate cut expectations
Jerome Powell spoke on April 16 at the Washington Forum, highlighting what the market had already priced in:
The labor market remains very strong as the unemployment rate remains under 4% for the longest period in more than half a century. However, recent data demonstrates a lack of progress on inflation heading toward the Fed’s 2% target. That means it will likely take longer for the central bank to gain confidence that inflation is headed lower.
While Powell has been very clear the Fed is data dependent, the market was pricing in a cooling off in inflation figures for the first half of the year, and thus rate cuts as early as June. It has become clear to all market participants that the respective scenario is no longer viable, and that the economy might be on a much firmer footing than everybody was expecting.
A strong economy and tight labor market translate into higher rates for longer. We do not think the Fed will hike again given the political implications in an election year, but they can just not touch the Fed Funds rate, all while tightening conditions via their messaging. We have seen that happen in the past week, with the intermediate portion of the yield curve and the long end much higher.
FLOT is set up to continue to deliver
The fund offers a 5.8% 30-day SEC yield via a portfolio of high grade corporate bonds:
The fund has an effective duration of only 0.02 years, and thus is not duration sensitive. Via its portfolio of investment grade bonds with a low duration, the name provides for an incremental spread (or OAS – option adjusted spread) to treasuries. The portfolio OAS is currently 45 bps.
The fund has outperformed treasuries in the past year:
FLOT is an instrument to be used for the current high interest rate environment as a cash parking fund. The vehicle will continue to deliver as long as short end rates stay high, and will provide an incremental spread to outright treasuries.
The spread comes with little risk since the market is now pricing in for a soft landing, and the probability for an investment grade name to default within a very short period of time is very low. The fund does contain a sizable portion of banking names, but most are large, systemically important institutions.
The risk metrics for this name are extremely appealing as well, with the Seeking Alpha ‘Risk’ tab showing a standard deviation of 1% and annualized volatility of 1.02%. Risk/reward metrics are extremely important in today’s environment, with many investments failing that litmus test. We can see from the above graph that FLOT generated a 7.2% total return in the past year. Many high yielding names have dividend yields close to 7%, but their drawdown profiles are somewhere around -15% to -20%. FLOT provides for an appealing total return given its risk profile.
While some investors are very risk-on oriented from a portfolio positioning standpoint, many retail individuals have certain dollar return figure needs. If you need to have $6k at the end of the year and you have invested $100,000, using an instrument like FLOT gives you a 99% certainty around obtaining that figure. Buying the SPY could generate much higher returns, but those returns also come with a substantially higher risk. Kindly remember that the index standard deviation is 19%.
FLOT does what it is supposed to very well, and will continue to post robust performances for as long as front rates are high.
Conclusion
FLOT is a fixed income ETF. The fund is a cash parking vehicle via its 0.02 years duration and investment grade portfolio. FLOT has managed to generate a 7% total return on a 1-year look-back, outperforming simple treasury funds. The vehicle has a portfolio spread of 45 bps currently, and will keep performing while Fed Funds are high. While the year started with six implied Fed cuts and market participants shunning floating rate instruments and tickers such as FLOT, the narrative has recently changed. With the Fed now forced to acknowledge that the economy is stronger than expected and inflation stickier than desired, higher for longer is what the market expects for 2024. Retail investors looking for very low volatility and a high yield can safely put their cash to work in FLOT. Under the new rates paradigm we are upgrading this name to Buy until the Fed actually starts cutting rates.