This article was first published to Systematic Income subscribers and free trials on March 28.
The Fed’s increasingly hawkish stance and associated bailout of longer-term rates has put many income investors on edge. back foot. In this article, we take a look at some of the floating rate investment options – securities that will see their income levels rise as the Fed continues its upward trajectory. Floating rate securities can not only generate an increasing level of income, but also maintain a defensive position if longer-term rates continue to rise.
The pricing landscape
That short-term rates will continue to rise is a virtual certainty. The current Fed funds rate has only been raised once, with the lower limit on the federal funds rate now at 0.25%, up from zero previously. By the end of this year, the Fed expects the Fed Funds rate to be just below 2% (with market consensus at 2%). He then expects to raise it further to around 2.75% (with a market consensus close to 3%). In short, the base case is that the short-term rate increases another 2-3% over the next two years.
A possible short-term rate hike was not exactly a secret and it is true that a hawkish pivot from the Fed as well as the current geopolitical crises were somewhat, but not entirely, unexpected. At the same time, the fact that higher rates were the subject of a clear consensus did not prevent most sectors (as approached by the benchmark ETFs in the chart below) from falling. 5 to 10% this year.
CEFs fared even worse with more than half of the sectors down double digits.
These developments raise two questions: how can investors allocate their resources to take advantage of rising short-term rates, and how can they potentially avoid or take advantage of declines since the start of the year. We explore this in the section below.
In this section, we highlight some floating rate income opportunities, that is, securities that are well positioned to profit from rising short-term rates. It is important for investors to keep in mind that income and price action are not always directly related. Specifically, securities whose underlying income (and, most likely, distributions) are expected to increase in the short term due to the continued rise in short-term rates may continue to experience high price volatility.
In short, just because incomes rise does not mean prices will also rise. It all depends on what happens to both longer-term rates and risky assets such as equities and credit securities. This is why it makes sense, in our view, to continue to position ourselves in the barbell – allocating both higher quality and higher yielding floating rate securities. Right now, the broader credit market is neither very cheap nor very expensive. Therefore, a balanced allocation makes sense to us.
Below, we highlight some of the floating rate options across the income space, ranging from higher quality to higher yielding ones.
On the very high quality side there is the WisdomTree Floating Rate Treasury Fund (USFR) and the iShares Treasury Floating Rate Bond ETF (TFLO) which hold floating rate treasury bills. The Invesco VRDO Tax-Free (PVI) ETF is only marginally lower in quality, which holds investment-grade muni VRDOs that are essentially tax-exempt muni money market securities. Yields from these are wrapped around zero but should start to rise shortly.
Staying in the high quality pocket, we would place something like the Janus Henderson AAA CLO ETF (JAAA) in the same bucket that holds AAA rated CLOs and has a February SEC yield of around 1% which, most closely resembles attractive option for us in this group apart from tax considerations. The fund’s yield is most likely closer to 2% on a future basis since the Libor is pegged in arrears, i.e. at the beginning of the period and therefore the current yield figures do not yet reflect the recent sharp rise in the Libor. The structure of CLOs (especially version 2.0 created after the GFC) is very robust and the historical default rate of rated CLOs has been exceptionally low, both in absolute terms and relative to corporate bonds.
Moving lower in the premium corporate space there is the SPDR Barclays Capital Investment Grade Floating Rate ETF (FLRN) as well as the iShares Floating Rate Bond ETF (FLOT) at yields of 0.5-1%. The Janus Henderson B-BBB CLO ETF (JBBB), which is a mostly BBB version of JAAA, is a very attractive decent quality choice with a 3-4% return which, again, is slightly lower quality, but still primarily investment grade. will also continue to increase.
For below investment grade corporate debt there are half a dozen loan ETF options at yields of around 4%. These include two actively managed funds: the SPDR Blackstone/GSO Senior Loan ETF (SRLN) and the First Trust Senior Loan Fund (FTSL). This yield will continue to rise as the Fed continues to climb and, if current market expectations are correct, it should reach close to 6% – a very attractive level for a low-duration, actively managed unleveraged fund. .
Investors should keep in mind that there are also funds that advertise themselves as variable rate preferred funds, such as the Global X Variable Rate Preferred ETF (PFFV) and the Invesco Variable Rate Preferred ETF (VRP); however, these primarily hold Fix/Float Preference Shares with current fixed coupons which may potentially have a floating rate after their redemption dates. These funds are down about 6% since the start of the year, which is certainly better than fixed rate preferred shares, but not exactly what most investors have in mind when think of floating rate securities. In short, these funds are not true floating rate funds.
Investors with a higher level of risk appetite and/or a higher target level of return should consider THIS F Where BDC. In the CEF space, we like Eagle Point Income Company (EIC) which is trading at a current yield of 9.26% and a fairly stable discount. The fund mainly holds lower quality CLO debt securities as well as CLO equities. The fund’s valuation isn’t cheap (for example, many lending CEFs are currently trading at double-digit discounts) and we have a Hold rating on the fund at the moment in our high-income portfolio.
We also like the Ares Dynamic Credit Allocation Fund (ARDC), which is trading at a 12% discount and a current yield of 8.5% which we recently highlighted here and have a Buy rating for in our portfolio. high income. Overall, after posting lofty discounted valuations for nearly half of the year, many lending CEFs are again trading at attractive valuations, making the space quite attractive to income investors.
In the BDC space, we like Golub BDC (GBDC), which trades at an 8% dividend yield and 99% valuation, and BlackRock TCP Capital Corp (TCPC), which trades at a in dividends of 8.5% and a valuation of 98%. Over the past 3-5 years, these two BDCs have generated strong returns ranging from high single digit to double digit to double digit annual total NAV, are trading at an attractive valuation and are very well positioned (better than average BDC) for a short-term upside. term rate. Their net income is expected to increase by almost 20% when the Libor rises to 2% from near zero – it’s already halfway there.
Take away food
The constant and continuous increase in short-term rates is one of the main dynamics of the current market environment. Floating rate assets have the potential to generate increasing levels of income over the coming years as the Fed continues to rise. They can also offer a more defensive position for potentially higher long-term rates, which we have already seen this year. The net asset values of CEF loans, for example, have held up much better than those of high yield bonds, outperforming 5% so far this year, while BDCs, which hold mostly floating rate loans, have actually advanced this year, unlike almost all other revenue sectors which are down for the year.