April 2nd, 2019
Fed induced selloffs are exciting times for bond pickers, as credit spreads tend to widen out while treasury rates move higher. This was the case in October 2018. Interest rates increased while spreads on many bond types began moving to their widest levels since 2016. The opportunity was short lived though, as the fed changed its message and fostered sharp bond appreciation from the 2018 lows. As a result, many investors are currently struggling to locate value in today’s market. While yields on most bonds are indeed lower, we feel a unique bond type is presenting relative value; US Treasury Floating Rate Notes.
These securities have cheapened in 2019 while the market moved to price in future interest rate cuts. Currently, market implied odds of one or more rate cuts by January of next year sit at 63.4% (CME Group FedWatch Tool). On the surface, it doesn’t seem sensible to own floating rate bonds if rate hikes aren’t on the horizon. We take a different view and believe these bonds are an interesting opportunity for the following reasons.
Yield – The 1/31/21 US Treasury Floater outyields all treasuries out to 11 years. With a current coupon of 2.528% (it pays the 3 Month T Bill rate + 0.115%) and a price of 99.95, these notes offer YTM of 2.555% given the current T-Bill rate. While the coupon can indeed change, the notes currently provide a 25 basis point yield advantage over two-year fixed rate treasuries and a 14.5 bp yield advantage over three-month bills.
Rate Outlook – While the fed appears likely to be on hold for a while, we see an unchanged fed funds rate as a possible outcome. In this scenario, we project the floating notes to outperform. Further, albeit less likely, we see future interest rate hikes as a possible scenario. In this case we feel the floaters will also outperform.
Historical Value – Since the treasury started selling floaters in 2014, buyers had to sacrifice yield. One example; when issued on 1/31/18, the US treasury two-year floaters offered 1.506% yield given the three-month bill rate at the time. This was 63.4 bps less than two-year fixed rate treasuries. Investors paid up for these due to the rate protection they offered. Today, these securities offer the same rate protection at a much better price point.
Matt DeLorenzo, Fixed Income Strategist