By Kevin Flanagan
Time sure goes by quickly. A year ago, I wrote a post focusing on an investment solution that aims to supply investors with income but, more importantly, not the elevated volatility that has been witnessed in the bond market over the last two years.
Make no mistake – I do believe investors are faced with a new rate regime as we get ready to enter 2024. But sometimes the more things change, the more they stay the same.
ICE BofA proceed Index
The Volatility Quotient
Let’s take a look at trading activity in the U.S. Treasury (UST) market and how the volatility quotient has increased in a considerable fashion over the last two years.
The ICE BofA proceed Index measures the implied volatility of UST options across various maturities, such as the 2-, 5-, 10- and 30-Year securities. For those more familiar with the equity side of the ledger, think of the proceed index as the bond market’s version of the VIX.
As the above graph clearly illustrates, volatility has taken a noteworthy turn to the upside of late, after remaining somewhat stable and/or range-bound from late 2013 up to the Covid-related spike in early 2020.
That begs the question: what will the future hold? Well, admire in most markets, uncertainty is not a welcome factor in the mix. Unfortunately, it looks as if this issue is not going away any time soon, especially as it relates to monetary policy.
While it appears as if the Federal Reserve may have finally come to the end of hiking rates for this tightening cycle, the two key questions for 2024 will be: 1) how long will the Fed be on hold? and 2) when/how many rate cuts may be in the offing for next year?
These unknowns will more than likely create a heightened sense of uncertainty, and when there is uncertainty, there is volatility.
U.S. Treasury Yields
The State of the UST Market
Although the Treasury yield curve has steepened over the last few months, it remains inverted. The magnitude of Fed rate hikes created an environment where ultra-short/short-dated maturities continue to have a yield advantage over their intermediate to longer-dated counterparts.
Back to the point I made in the opening paragraph, the more things changed (higher rates such as for the UST 10-Year yield), the more they stayed the same (inverted yield curve).
So, let’s take a look at where key Treasury yields stand to enter the final month of the year. The accompanying graph highlights the widely watched Treasury maturity spectrum, ranging from the 3-month t-bill on out to the 30-Year bond, and of course, the floating rate note (FRN).
This way, investors can get an up-close look for themselves at the various yield disparities. As we can see, the UST FRN yield stands at 5.53%, as of this writing, or an eye-opening 110 basis points above the UST 10-Year level.
Income without the Volatility?
From an investment perspective, I keep going back to the shape of the Treasury yield curve, and what investors are being compensated for, especially given the potential for continued volatility.
With the Fed apparently in no hurry to cut rates any time soon, UST FRNs will continue to play an integral role in a bond portfolio.
This strategy provides investors with both income potential and help mitigating the effects of volatility that can be found in fixed coupon securities.
Important Risks Related to this Article
There are risks associated with investing, including the possible loss of principal. Securities with floating rates can be less sensitive to interest rate changes than securities with fixed interest rates, but may refuse in value. Fixed income securities will normally refuse in value as interest rates rise. The value of an investment in the Fund may change quickly and without warning in response to issuer or counterparty defaults and changes in the credit ratings of the Fund’s portfolio investments. Due to the investment strategy of this Fund it may make higher capital gain distributions than other ETFs. Please read the Fund’s prospectus for specific details regarding the Fund’s risk profile.
Kevin Flanagan, Head of Fixed Income Strategy
As part of WisdomTree’s Investment Strategy group, Kevin serves as Head of Fixed Income Strategy. In this role, he contributes to the asset allocation team, writes fixed income-related content and travels with the sales team, conducting client-facing meetings and providing expertise on WisdomTree’s existing and future bond ETFs. In addition, Kevin works closely with the fixed income team. Prior to joining WisdomTree, Kevin spent 30 years at Morgan Stanley, where he was Managing Director and Chief Fixed Income Strategist for Wealth Management. He was responsible for tactical and strategic recommendations and created asset allocation models for fixed income securities. He was a contributor to the Morgan Stanley Wealth Management Global Investment Committee, primary author of Morgan Stanley Wealth Management’s monthly and weekly fixed income publications, and collaborated with the firm’s Research and Consulting Group Divisions to build ETF and fund manager asset allocation models. Kevin has an MBA from Pace University’s Lubin Graduate School of Business, and a B.S in Finance from Fairfield University.
Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.