Variable income options for a more hawkish Fed stance
This article was first published on March 28th for Systematic Income subscribers and free trials
The Fed’s increasingly hawkish stance and associated support for longer-term interest rates has left many income investors upset back foot. In this article, we take a look at some of the adjustable rate investment options – securities that will see rising income levels as the Fed continues its rate hike streak. Floating rate securities can not only deliver increasing levels of income, but also maintain a defensive position if interest rates continue to rise at the longer end.
The tariff landscape
It is almost certain that short-term interest rates will continue to rise. The current Fed interest rate has only been raised once, with the Fed Funds rate floor now at 0.25% from previously zero. By the end of this year, the Fed expects to cut the fed funds rate to just under 2% (on a market consensus of 2%). It then expects another hike to around 2.75% (on a market consensus of almost 3%). In short, the base case is that short-term interest rates rise another 2-3% over the next few years.
An eventual rise in short-term interest rates was no secret, and it is true that a hawkish Fed change and the current geopolitical crises were somewhat, if not entirely, unexpected. At the same time, the fact that higher interest rates was a clear consensus didn’t stop most sectors (as represented by benchmark ETFs in the chart below) from falling 5-10% this year.
CEFs have performed even worse, with more than half of the sectors down by double digits.
These developments raise two questions: how can investors allocate to take advantage of rising short-term interest rates, and how can they potentially avoid or take advantage of the year-to-date declines? We examine this in the following section.
In this section, we highlight some variable rate income opportunities, ie those securities that are well positioned to benefit from rising short-term interest rates. It is important for investors to remember that earnings and price movements are not always directly linked. In particular, securities where underlying income (and, most likely, distributions) are expected to increase in the short term due to continued rises in short-term interest rates may continue to be subject to increased price volatility.
In short, just because revenue is going up doesn’t mean prices will go up. Everything depends on what happens to both longer-term interest rates and risky assets like stocks and loan collateral. For this reason, we think it makes sense to continue to position in the barbell fashion – allocating to both higher quality and higher yielding floating rate securities. Right now, the broader credit market is neither insanely cheap nor insanely expensive, so a balanced allocation makes sense to us.
Below we highlight some of the variable rate options across the broader income spectrum, moving from higher quality to higher yielding securities.
on the very high quality site there’s the WisdomTree Floating Rate Treasury Fund (USFR) and the iShares Treasury Floating Rate Bond ETF (TFLO), which hold floating rate Treasuries. Only slightly worse is the Invesco VRDO Tax-Free ETF (PVI), which holds investment-grade muni VRDOs, which are essentially tax-exempt muni money market securities. Their return is around zero, but is likely to rise again shortly.
To stay in the high-quality bag, we’d put something like the Janus Henderson AAA CLO ETF (JAAA) in the same bucket, which holds AAA-rated CLOs and has an SEC yield of about 1% as of February of about 1% , which looks like the best outside of tax considerations, is an attractive option for us in this group. The Fund’s yield is very likely closer to 2% as Libor is defaulting early in the period and current yield figures do not yet reflect the recent sharp rise in Libor. The CLO structure (particularly version 2.0 created after the GFC) is very robust and the historical default rate for rated CLOs has been exceptionally low, both in absolute terms and relative to corporate bonds.
Move deeper into the Investment grade corporate space there is the SPDR Barclays Capital Investment Grade Floating Rate ETF (FLRN) as well as the iShares Floating Rate Bond ETF (FLOT) with returns of 0.5-1%. Slightly lower quality but still mostly investment grade is the Janus Henderson B-BBB CLO ETF (JBBB) which is a mostly BBB version of JAAA and is a very attractive pick of decent quality with a 3-4% yield , which in turn will also continue to rise.
To the Sub-investment grade corporate bonds There are half a dozen credit ETF options that yield around 4%. This includes two actively managed funds: the SPDR Blackstone/GSO Senior Loan ETF (SRLN) and the First Trust Senior Loan Fund (FTSL). That yield will continue to rise as the Fed tightens further and, if current market expectations are at all accurate, should peak not far from 6% – a very attractive level for an actively managed, unleveraged, low-duration fund.
Investors should note 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 mostly hold fix/float preferred stocks with fixed current coupons that may have a variable interest rate after their redemption dates. Those funds are down about 6% year-to-date, which is certainly better than fixed-income preferred stocks, but not exactly what most investors have in mind when they think of floating-rate securities. In short, these funds are not true floating rate funds.
Investors with a higher risk tolerance and/or higher return target should consider this CEF’s or BDC’s. In the CEF space, we like Eagle Point Income Company (EIC), which is trading at a current yield of 9.26% at a fairly flat discount. The fund mainly holds sub-investment grade CLO debt and some CLO equities. The fund’s valuation is not cheap (e.g. many credit CEFs are currently trading at double digit discounts) and we currently have a hold rating on the fund in our high income portfolio.
We also like the Ares Dynamic Credit Allocation Fund (ARDC), which trades at a discount of 12% and a current yield of 8.5%, which we recently highlighted here and have in our high-income portfolio have a buy recommendation. Overall, after boasting expensive discount valuations for nearly half the year, many credit CEFs are trading again at attractive valuations, making the space quite attractive for income investors.
In the BDC space, we like Golub BDC (GBDC), which trades with an 8% dividend yield and a 99% valuation, and BlackRock TCP Capital Corp (TCPC), which trades with an 8.5% dividend yield and a 99% valuation Rating of 98% is traded. These two BDCs have produced strong returns in the high single digits to low double digits in terms of total annual NAV over the last 3-5 years, trade at attractive valuations and are very good (better than average BDC) for rising short -Positions positioned. runtimes. Your net income is expected to increase by nearly 20% as Libor rises from near zero to 2% – it’s already about halfway.
The steady further increase in short-term interest rates is one of the most important dynamics in the current market environment. Floating rate assets can deliver rising returns in the coming years as the Fed tightens further. They can also provide a more defensive position for potentially higher interest rates at the longer end, which we’ve seen earlier this year. Credit CEF NAVs, for example, have held up much better than high-yield bonds, outperforming by 5% so far this year, while BDCs, which hold mostly adjustable-rate debt, have outperformed nearly everyone else this year actually gaining are other income sectors that are down for the year.