iShares Treasury Floating Rate Bond ETF (NEW YORK:TFLO) has been a solid near-cash investment for many investors over the past year, as it enjoyed higher coupons that were tied to short-term growth Interest rates.
However, as we head into 2024, I believe investors should be wary of possible rate cuts by the Fed. If inflation continues to moderate, then the Fed may have to cut interest rates in order not to ‘squeeze’ the economy into a recession.
Summary of the Fund
The iShares Treasury Floating Rate Bond ETF provides the investment performance of holding floating rate Treasury bonds by tracking the Bloomberg US Treasury Floating Rate Index.
The TFLO ETF has over $10 billion in assets and charges a relatively low net expense ratio of 0.15% (Figure 1).
Floating Rate US Treasury Notes
The US Treasury began issuing floating rate notes (“FRNs”) in 2014, and total issuance has grown to $586 billion as of September 30, 2023. Although the absolute numbers are large, FRNs only account for about 2% of the treasury market (Figure 2).
Mechanically, Treasury FRNs pay a coupon that matches the discount rate of the most recent 13-week Treasury bill auction plus a ‘fixed spread’ that is determined at the time of issuance. Therefore, with the change in the 3-month bond rates, the coupons paid by the Treasury FRNs also change (Figure 3). In effect, Treasury FRNs act like 3-month T-bills, without the current difficulty of T-bills circulating every 3 months.
Mechanically, the TFLO ETF is very similar to the WisdomTree Floating Rate ETF (USFR) that I keep in my personal portfolio and I have written many ARTICLES circle. TFLO’s portfolio consists entirely of Treasury FRNs, with maturities from 0 to 2 years (Figure 4).
Currently, TFLO’s portfolio is split between 8 different Treasury FRNs plus a small amount of cash (Figure 5).
Distribution & Yield
The TFLO ETF has a 30-day SEC yield of 5.34% and pays a monthly distribution. TFLO’s trailing 12-month distribution is $2.35/share or 4.64%, but the distribution rate has been rising as the Fed has raised fed funds rates, which lead to higher Treasury yields (Figure 6).
Figure 7 shows the historical returns of the TFLO ETF. Investors should not hope to strike it rich with funds like TFLO. However, it provides an excellent way to earn short-term Treasury yields while protecting capital, with zero credit (Treasury-backed notes) and interest rate (floating rate) risk.
The CPI slowdown increases the risk of a rate cut in 2024
In the last one ITEM in the USFR ETF, I noted that the Federal Reserve held the Fed Funds rate steady for a second consecutive FOMC meeting, leading some investors to speculate that the Fed may be done with raising interest rates this cycle. In fact, the question now is when the Fed will cut interest rates in the coming months. Market expectations for a rate cut shifted to May 2024 after the November FOMC meeting.
This pessimistic interpretation was further strengthened this week when the Bureau of Labor Statistics (“BLS”) reported a negative surprise in the Consumer Price Index (“CPI”), with better-than-expected readings in both the headline and in the basic CPI. Headline CPI came in at 3.2% y/y versus consensus calling for 3.3% while core CPI was 4.0% versus estimates of 4.1% (Figure 8).
While still higher than the Fed would like, the inflation trend is clearly softening toward the Fed’s target (Figure 9).
Why might a slowing inflation reading prompt the Fed to cut rates?
The answer lies in real interest rates. We can roughly think of real interest rates as the Fed Funds rate minus the core inflation rate. In other words, when the Fed Funds rate is above core inflation, it is considered ‘restrictive’ and is most likely to slow the economy.
However, what happens when inflation starts to fall steadily, as it has in recent months? As inflation begins to decline, the spread between the Fed Funds rate and inflation begins to widen, ie monetary policy becomes increasingly restrictive on the economy, even if the Fed simply holds the Fed Funds rate steady (Figure 10).
If inflation continues to slow in the coming months, then by holding the Fed funds steady, the Fed will actually be ‘tightening’ monetary policy.
Since the Fed’s mandate is price stability and maximum employment, it is not in their interest to force the economy into a deep recession just to lower inflation. Instead, I believe that if inflation continues to moderate in the coming months, the Fed may feel the need to cut the Fed funds rate several times so as not to put too much pressure on the economy.
The Fed funds rate and Treasury bond rates are ultimately tied
For floating-rate Treasury bond funds like the TFLO ETF, this scenario would be a headwind, since the Fed funds rate and Treasury bond yields are inextricably linked (Figure 11).
If and when the Fed lowers the Fed funds rate, we should expect a reduction in coupon payments for the TFLO ETF.
Therefore, my plan is to gradually shift my Treasury holdings (currently held in USFR and SGOV ETFs) to 2-year notes and funds in the coming months ahead of an expected Fed rate cut -it, in order to ‘lock in’ high short-term yields and maintain portfolio flexibility.
The TFLO ETF provides exposure to floating rate Treasury notes, similar to the USFR ETF. Floating-rate funds have been a great place to hide in the past year, as they enjoyed the boost in yields from the Fed’s rate hikes without any credit risk.
However, as we move into 2024, I believe investors should start looking for the exits, as it looks increasingly likely that the Fed will cut interest rates in the coming quarters if inflation continues to soften. By not cutting interest rates, the Fed risks applying mechanical pressure to the economy.
I rate TFLO a STAY.