We have been asked recently why we are using an ultra-short-term, investment-grade, floating rate debt fund instead of some other higher yielding debt fund in the Loan allocation.
The short answer is that ultra-short-term, investment-grade, floating rate debt is currently most attractive considering inflation, taxes, rising Fed Funds rates, and degree of correlation with stock market price changes and stock market event risk.
That more attractive status will continue until the Federal Reserve has substantially completed its interest rate normalization program sometime in 2019.
The blue line in this chart is the actual Federal Funds rate; and the red line is the Federal Reserve forecast of where they expect the Federal Funds rate to go. You can see that the forecast is for about 3.4%. The current 10-year Treasury rate is about 3.2% which will surely rise as short-term rates rise.
Looking across the various types of debt available in mutual funds and ETFs, it is clear to us that ultra-short-term, investment-grade, floating-rate debt (“UST-IG-FR”) is the best current choice.
Senior floating-rate bank loans will probably have higher return after inflation, after taxes, after Fed rate increases than UST-IG-FR debt, but with significantly higher credit risk, and significant stock market “event risk”. Due to low loan quality, bank loan debt has significant correlation with stock market price moves, and limited liquidity in a crisis. T-Bills will have essentially no credit risk or stock market event risk but lower return than UST-IG-FR debt after inflation, taxes and Fed rate increases.
At this late stage in the stock market cycle, using debt with a high correlation to the stock market is not good risk management.
We expect to redeploy our Loan allocation to longer duration debt sometime in later 2019, based on the published schedule of rate increases from the Federal Reserve.
This is how the prices of T-Bills, UST-IG-FR debt and senior banks loans did over the past 12-months as the Fed Funds rate rose 1.02% over those 12-months.
The following charts plot the price change of funds representing key debt categories over the past 12-months, during which the Federal Reserve raised the Fed Funds Rate (the base rate for USA debt) by 1% in 0.25% increments at a steady pace.
We make the simplistic assumption that the funds will experience a repeat of price changes over the next 12 months that they experienced over the last 12 months. That is because the Federal Reserve rates over the next 12 months are expected to rise by the same amounts, at the same pace, over the next 12 months as they did over the lasts 12 months.
The next table illustrates our view on key debt types and shows UST-IG-FR debt as one of three categories with expected positive return after inflation, after taxes, after a 1% Fed Funds rate increase over the next 12 months. The other two are 1-3-month Treasury Bills and senior, floating rate bank debt.
UST-IG-FR debt has a lower net yield than Senior Bank Loans, but much lower credit risk and much lower stock market event risk. UST-IG-FR has some minor credit risk being rated “A” and minimal stock market event risk.
If essentially zero credit risk and essentially zero stock market event risk is the goal, then T-Bills are the way to go. However, we think Ultra-Short-Term, Investment-Grade, Floating Rate Debt is where we want to be at this time and until the Fed substantially completes rate normalization in 2019.
For the “Duration Price Effect”, we make the assumption that the price behavior over the last 12 months during a 1% Fed Funds rate increase will be duplicated over the next 12 months during which the Fed’s behavior is expected to be the same as the last 12 months. The Fed raised its base rate 1% over 12 months and plans to do the same over the next 12 months.
The Maximum Drawdown is a measure of the largest drop from a peak to a trough during the indicated period.
You can see that an estimate of the total return after inflation, after taxes and after duration price effect is 0.04% for T-Bills, 0.35% for UST-IG-FR debt and 0.81% for senior floating rate bank debt (note this sort of bank debt has major potential liquidity problems during a crisis).
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