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US Treasury Floaters – A Contrarian Opportunity for Cash

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

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January FOMC Minutes Review #FOMC

The market’s initial response to the FOMC minutes implies a mildly dovish interpretation. Some investors found comfort in the idea that the balance sheet runoff may conclude this year. Others are unconvinced that this is what the fed intended to signal. The rationale is that the fed only signaled that an announcement would take place this year, rather than a firm 2019 end date. Considering the following quotes from the minutes, I think it’s clear that they do indeed intend to end QT this year.

Page 10 “Against this backdrop, the staff presented options for substantially slowing the decline in reserves by ending the reduction in asset holdings at some point over the latter half of this year and thereafter holding the size of the SOMA portfolio roughly constant for a time so that the average level of reserves would fall at a very gradual pace reflecting the trend growth in other Federal Reserve liabilities.”

Page 11 “Almost all participants thought that it would be desirable to announce before too long a plan to stop reducing the Federal Reserve’s asset holdings later this year.”

Another interesting point is that some participants may prefer to continue reducing the portfolio’s MBS holdings while reinvesting in treasuries only. This could push mortgage spreads wider over time.

Page 12 “Participants commented that, in light of the Committee’s longstanding plan to hold primarily Treasury securities in the long run, it would be appropriate once asset redemptions end to reinvest most, if not all, principal payments received from agency MBS in Treasury securities.”

To me, the biggest question from here is; WHEN in 2019 will QT end? While the fed has communicated its willingness (and perhaps its intention) to end QT this year, a whole 10 months remain in 2019. Given the current cap of $50B/month, the amount of reduction can actually wind up exceeding that of 2018. Remember, the cap (max monthly reduction) didn’t hit $50B until October 2018. There hasn’t been a big market response to the minutes, but this may not wind up being as supportive as it seems on the surface.
 

 

Matt DeLorenzo, Fixed Income Strategist

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LIBOR to SOFR – Preparing for Changes #LIBOR #SOFR #bonds

Largely due to its history of scandal and manipulation, LIBOR is being phased out. While this isn’t new information, we’ve been tracking updates here at United. The rate is being replaced with SOFR, or the Secured Overnight Financing Rate. Since many financial obligations with floating rate structures are tied to LIBOR, we feel this transition and the accompanying details is very important. Some details remain to be hammered out, but we note some of these relevant points:

  • LIBOR is expected to be completely phased out by Q4 2021. SOFR is the replacement rate.
  • The transition will primarily impact longer dated bonds and obligations. Many will mature before Q4 2021 and thus won’t be impacted.
  • SOFR is naturally a lower rate than LIBOR. This is partly due to the fact that SOFR is a secured rate, while LIBOR is supposed to reflect the credit risk of financial institutions.
  • SOFR can only be observed back to 2014, but it tracks fairly close to the fed funds rate.
  • Given that LIBOR is a higher rate than SOFR, a direct replacement would abruptly change the rate on many financial instruments. Since this would be very problematic, there is likely to be a ‘spread adjustment’ of about 10 basis points. An obligation that previously paid 3 Month LIBOR + 100 basis points would in theory be converted to SOFR + 110 basis points.

While the transition will impact many types of financial obligations, we are most interested in its impact on LIBOR linked bonds, preferred stocks and bank loans. We find that in situations like this, refining our understanding ahead of time helps us to identify value for clients when dislocations occur.
 

Matt DeLorenzo, Fixed Income Strategist
 

https://www.newyorkfed.org/arrc/governance.html

https://www.isda.org/a/g2hEE/IBOR-Global-Transition-Roadmap-2018.pdf

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September CPI Report Review #CPI #Bonds #Inflation

The September CPI numbers came in a little bit cooler than expectations.  Headline rose 2.3% YOY v expectations of 2.4%.  Core CPI rose 2.2% YOY v expectations of 2.3%. 

While energy comps made the decline in headline CPI predictable, yesterday’s miss made the deceleration more dramatic.  For comparison; August’s YOY number was 2.7%. v September’s 2.3%.  A large drop in used car prices (-3%) and tame rent growth (+0.2%) for the month contributed to the core miss.  The shelter/rent numbers warrant close watching as concerns of a top/slowdown in housing grow.  Shelter makes up about a third of the index so a continued slowdown here could squash fears of inflation getting out of hand. 

This report, the declining stock market, yesterday’s strong long term bond auction and lower oil boosted confidence in high quality fixed income.  Given the speed of the recent selloff (the 30 year bond yield rose 46 basis points from 8/24 – 10/5) webelieve the bounce and some temporary stabilization makes sense.  With that being said, headwinds persist.  They include:

  • The fed continues QT (cap for monthly reduction is now $50B)
  • The fed continues to signal additional interest rate hikes
  • The ECB has reduced its QE pace to Eur 15B/month and plans to stop adding bonds at year end
  • US treasury supply continues to increase
  • Energy comps make  re-acceleration of YOY CPI look likely for the October report (released next month)
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The Return of Volatility

2017 was a year characterized by abnormally low levels of market volatility. To put this in perspective, there were only 8 trading days in 2017 where the S&P 500 Index moved more than 1% and NO 2% moves. Volatility has returned in 2018, with 14 trading days with 1% moves and 3 trading with 2% moves.

In our view, concerns about inflationary pressures, policy uncertainty and geo-political risks will result in ongoing market volatility. United Asset is well prepared for this return to volatility, as many of our investment offerings include active management with a focus on downside risk management; the hallmark of United’s investment philosophy.

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