There are expectations the Federal Reserve will commence lowering interest rates as soon as next month. That potentially will start an extended monetary loosening campaign. So it’s logical many fixed income investors are considering embracing duration. On the other hand, those market participants may be overlooking floating rate notes and ETFs like the WisdomTree Floating Rate Treasury Fund (USFR ) as tools for preparing for the Fed’s next move.
Indeed, USFR’s duration is just 0.02 years. But the fund can help investors split the difference between capitalizing on a possible rate cut and preparing for the specter of related disappointment. That’s a benefit offered by floaters that’s hard to find in other corners of the bond market.
“Rates available on short-term investments may be lower than the investor is willing to accept. Floaters offer an alternative which pays a spread above current short-term rates and also enjoys the benefit of future rate increases,” according to Raymond James.
One reason floaters, including USFR components, can thrive regardless of interest rates is these bonds are issued with caps and floors. The cap is the highest interest rate an issuer will pay regardless of what reference rates are doing. The floor is the minimum such rate.
Understanding USFR Rate Resilience
Some experts argue that economic data, namely inflation and jobs, isn’t necessarily supportive of the Fed cutting rates, let alone at an aggressive pace. Those are certainly points to consider. And they could highlight the utility of the reset mechanism found with floaters, including the bonds residing in USFR.
“It is quite common for the coupon to reset each time an interest payment is made, and then remain constant until the next coupon payment date. If the floater resets more frequently than interest is paid, the coupon payment will generally reflect the average of each reset since the previous interest payment,” added Raymond James. “For example, a monthly reset/quarterly pay floater’s interest payment would reflect the average of the three monthly resets that occurred in the previous quarter.”
Another point in favor of floaters and ETFs like USFR is there’s often a vibrant secondary market for these bonds. That implies robust liquidity, which can keep total cost of ownership palatable to advisors and clients.
Opportunity to Sell at Prevailing Market Levels
“Floaters are most suitable for purchasing and holding to maturity. However, investors may find it necessary to sell their floating-rate investment prior to maturity. Floaters may be traded in the secondary [market. That] provides an opportunity for investors to sell them at then prevailing market [levels. And that] may be more or less than the purchase price,” concluded Raymond James.
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