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Main Thesis
The purpose of this article is to evaluate the iShares Floating Rate Bond ETF (FLOT) as an investment option at its current market price. This is a fund I had been recommending last year, as rising interest rates made floating rate debt (whose rates will re-set at given intervals) a more attractive option. While the fund did perform well in 2018, this year as been a different story, as floating rate debt has lagged fixed-rate. This performance was anticipated, and was a key reason why I cautioned against positions heading in to the new year.
The reason for this is primarily due to the Fed’s more cautious interest rate outlook. The Fed has paused interest rate hikes, and the market is actually anticipating 1-2 rate cuts by year-end, which is a completely different environment than what we saw last year. While default rates in the investment -grade space are low, supporting asset values in both floating and fixed rate funds, FLOT will likely continue to under-perform unless there is a fundamental shift in Fed direction. With a yield that matches risk-free fixed rate products, such as treasuries and certificates of deposit, I continue to see little reward in buying in to FLOT at this time.
Background
First, a little about FLOT. The fund “seeks to track the investment results of an index composed of U.S. dollar-denominated, investment-grade floating rate bonds with remaining maturities between one month and five years.” It offers investors exposure to U.S. floating rate bonds, whose interest payments adjust to reflect changes in interest rates. FLOT currently trades at $50.37/share and pays a monthly distribution, with a current yield of 2.93%, based on its most recent payout. I reviewed FLOT most recently in December, when I advised investors to consider other fixed-income assets in 2019. Since that time, FLOT has seen a positive return of 2.28%, after accounting for distributions. While this sounds good in isolation, the fund has indeed lagged non-floating investment grade debt so far in 2019. This is a trend I see continuing for the remainder of the year, making me reluctant to change my previous outlook, and I will explain why in detail below.
Fixed Rate Is Winning in 2019
I want to start by illustrating the primary reason why I remain unconvinced FLOT is the right investment play for the remainder of the year. Specifically, this has to do with performance. While the fund is positive for the year, so is the majority of the fixed income market, so that is not enough of a differentiator to warrant a buy signal. Furthermore, when compared to its fixed-rate counterpart, the iShares Core U.S. Aggregate Bond ETF (AGG), the under-performance is clear. AGG is a fund which tracks the investment results of an index composed of the total U.S. investment-grade bond market (not just floating rate investment grade debt like FLOT) and is handily beating FLOT on a year-to-date basis, as illustrated in the graph below:
Source: CNBC
As you can see, this outperformance has widened over the past few months, which gives the impression that this is an accelerating trend that is likely to last. As volatility has increased in the market, the outlook for interest rates has softened, and this is having a marked impact on the performance spread between FLOT and AGG. My point here is that the conditions that have led to AGG’s out-performance are likely to continue in the short-term, so I view AGG, or other fixed-rate options, as the more lucrative opportunity going forward.
Main Concern – Dovish Outlook in 2019
As I mentioned in the preceding paragraph, a primary reason for FLOT’s under-performance has been the dovish interest rate outlook for this year, which is a complete turnaround from 2018. With FLOT being a fund that capitalizes on a rising rate environment, the absent of further rate hikes makes the fund less attractive. While I am not overly concerned about the fund’s performance, relative to fixed-rate, if interest rates stay neutral, a declining interest rate environment would be particularly painful. This is because the income stream for FLOT would decrease, while fixed-rate funds should see their income stream remain constant.
With this in mind, it is important to consider the market’s current interest rate outlook, which has changed substantially since the beginning of the year. Given concerns over global trade, slowing economic growth, and declining corporate profits, investors have currently concluded interest rates will end the year lower than where they sit right now. Heading in to 2019, it looked like 1-2 interest rate hikes were on the table, but now the market is pricing in 1-2 cuts, which is a marked shift. According to data compiled by CME Group, which tracks investor sentiment regarding potential interest rate movements, the likelihood of rates remaining neutral by year-end has been declining rapidly, and sits at under 25%, as illustrated in the chart below:
Source: CME Group
My takeaway here is this is quite negative for FLOT, when compared against fixed-rate options. Funds like AGG do not have the same level of risk of a declining income stream, and that risk appears to be very real for FLOT in the near term. Therefore, investors may find themselves wanting to lock in fixed-rate yields, before rates begin to decline. The disparity is that if you were to buy AGG now, you know you will receive the current yield on your current investment, even if the yield declines going forward to new purchases. With FLOT, you do not have that same dynamic, making the fund less attractive. Given that FLOT is lagging, and its outlook is less rosy, I have a difficult time getting behind this fund at the moment.
Risk-Free Options Offer Comparable Yields
Another point against FLOT is something I brought up the last time around, which is that risk-free rates are offering similar yields. While FLOT is currently yielding 2.93%, that is not much of an incentive to own a fund that has default risk, when short-term certificates of deposit are yielding just under that level, as illustrated in the graphic below:
Source: BankRate.com
While default risk among investment-grade debt is indeed low, it is not zero, and the account options above offer a similar level of income without that risk. Furthermore, that does not even take in the possibility of FLOT’s yield seeing declines by year-end. If FLOT does see a drop in income, its yield could fall below the 2.70 – 2.80% mark shown above, while still carrying that default risk. To me, this risk/reward opportunity simply does not make sense. While certificates of deposit do not offer the chance of price appreciation the way bonds do, they do protect against the downside risk, and offer a viable alternative given current interest rates.
Investment Grade Not What It Used To Be
My final point concerns the investment grade debt market broadly, and is not specific to FLOT, although it does have implications for the fund. Specifically, I am referring to the declining credit rating environment within the investment grade space. As interest rates have stayed low for years, corporations large and small have racked up debt, and that has strained credit ratings across the market. In fact, both globally and domestically, BBB-rated (or the lowest rated category for investment grade credit) is making up a large share of the market. The graph below speaks for itself in this regard:
Source: S&P Global
As you can see, the AAA and AA ratings are making up a very small portion of the outstanding corporate debt, with A and BBB growing in importance. This could pressure both investment grade and high-yield credit markets if financial conditions tighten and/or defaults increase. The downgrades would hurt the current income in the investment grade space, as well as investor confidence in the companies that remain in the investment grade category. It would also hurt the high-yield market as the increase in supply (due to the downgrades) could impact asset prices if investor demand does not make up for that increase. With interest rates remaining low, and likely to drop, I do not see this is a large risk right now, but it is something to be aware of.
Furthermore, this dynamic has implications for FLOT, as the fund is indeed made up of mostly A and BBB debt, as illustrated below:
Source: iShares
My takeaway here is not to flee fixed-income all together, quite the contrary, as I see this asset class as an increasingly important component of a diversified portfolio given our current market volatility. However, it does mean investors need to remain critical on what types of funds they buy, and at what prices. Simply buying “investment grade” funds may not actually be giving investors the safety they are looking for, as ratings within that space have been trending lower. Therefore, investors need to be keenly aware of what type of debt they are buying, and I would skew towards higher-rated investment grades, with fixed rates over floaters.
Bottom-line
Fixed-income has rallied in 2019, as the Fed put the breaks on further rate hikes and investors began a renewed hunt for income. While FLOT has moved higher along with most of the market, I stand by my call to consider other options this year. While FLOT is up, its performance has lagged its fixed-rate counterparts, such as AGG. Furthermore, the income stream, which increased broadly last year, has flattened, with the potential for declines later this year if rates drop. Furthermore, risk-free assets are now offering comparable yields, which makes me question whether the default risk offered by FLOT is worth it, considering the deterioration of credit ratings within the investment grade space. Therefore, I see little benefit in investing right now, and continue to recommend investors look elsewhere for income.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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