Amid expectations that the worst case scenario for interest rates this year is that the Federal Reserve will halt its tightening cycle, some fixed income investors may be inclined to take their eyes of floating rate notes (FRNs).
Time will tell, but that could be a regrettable decision. Take the case of the WisdomTree Floating Rate Treasury Fund (USFR ). USFT, which follows the Bloomberg U.S. Treasury Floating Rate Bond Index, has served investors through a rough period for bonds. Over the past two years, the WisdomTree exchange traded fund rose 7.5%. Meanwhile the widely followed Bloomber US Aggregate Bond Index slumped 7%.
Add to that, USFR’s annualized volatility over that span was just 0.5% compared to 7.8% for the “agg.” The advantages offered by the $17.58 billion USFR don’t imply a reduced level of income as highlighted by the fund’s 30-day SEC yield of 5.42%.
USFR Volatility Perks Are Meaningful
As noted above, USFR delivers significantly reduced volatility relative to aggregate bond strategies – a trait that’s “all weather” in nature. It could prove particularly beneficial this year. Treasury yields could decline in short order or surprise (negatively) to the upside.
“The main catalyst for these downward movements is continued optimism the Fed will cut rates aggressively this year. Implied probabilities for Fed Funds Futures are pricing in six to seven rate cuts for 2024, worth a total of at least 160 bps,” noted Kevin Flanagan, head of WisdomTree fixed income strategy. “This scenario would put the Fed Funds target range between 3.50% and 3.75%. Arguably, one can make the case that the UST market has already priced in a lot of good news, and as we’ve seen many times in the past (2023 included), the track record for the implied probability measure is not very good. In other words, there is definitely room for disappointment on this front.”
Much of USFR’s volatility advantage is a duration story. As of Jan. 22, the ETF’s effective duration is just 0.02 years. That’s noteworthy for rate-sensitive investors while underscoring the aforementioned 30-day SEC yield, which is arguably high for such a low duration product. Methodology explains USFR’s benefits.
“"USFR":https://www.wisdomtree.com/investments/etfs/fixed-income/usfr is tied to the UST 3-month t-bill auction yield, which is directly tied to the actual Fed Funds Rate, not an expectation, such as what is being discounted by the fixed coupon sector,” added Flanagan. “Why is that important? Because the Fed hasn’t cut rates. The 3-month t-bill yield is essentially unchanged vs. the declines in the 2-, 5- and 10-Year yields I mentioned earlier.”
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