FLOT and AGG: opt for a combined fixed and variable income portfolio
In my quest for portfolio diversification, I came across the iShares Floating Rate Bond ETF (BAT:FLOAT) which, as shown in the blue chart below, has withstood volatility much better than the iShares Core US Aggregate Bond ETF (NYSEARCA:AGG) as it became clear that the Federal Reserve would have to raise rates to fight high inflation.
However, after six interest rate hikes by the US central bank, many are now expecting or hoping for a pivot, and with higher quality yields now above 2%, more investors are tempted by high quality fixed income securities. However, this thesis is of the opinion that even after an 18% decline, now is not the time to enter core bonds unless it is done as part of a combined portfolio strategy. which includes bonds that pay variable rate interest.
To that end, I will also show how a portfolio comprised of both AGG and FLOT has historically outperformed a portfolio comprised exclusively of core bonds.
I start by differentiating between fixed rate and variable rate income.
Difference Between AGG and FLOT
For those new to this space, most bonds like AGG have a fixed interest rate. You know in advance exactly what interest you will receive over the term of the bond. However, in the world of corporate debt, there are also floating interest rate bonds where the coupon payments received are adjusted against a benchmark rate, such as LIBOR.
Here, one of the advantages of FLOT over searching for individual issuing companies is that it aggregates over 380 in one fund. These are shorter-term bonds (with maturities ranging from one month to five years) of higher quality with a 12-month yield of 1.36%.
Now, as noted above, AGG also consists of higher quality bonds with a higher average yield of 2.28%. However, its weighted average maturity of 8.55 years is higher than FLOT’s of 1.74 years, which means that AGG has a longer duration.
To explain the yield differential, buying longer duration core bonds means taking on more risk, which is why investors are rewarded with a higher yield. In this regard, the iShares 10+ Year Investment Grade Corporate Bond ETF (IGLB) with maturities greater than ten years yields returns of 4.90%.
On the other hand, the shorter-duration FLOT pays a lower yield of 1.36%, but its monthly payments have increased rapidly, as data calculated by SA shows, due to interest payments adjusted to reflect variations. Fed rates. By comparison, AGG’s monthly dividends have also grown, but at a much slower rate, and considering the year-over-year capital depreciation of over 18% according to the introductory chart, people who have invested in the ETF at the start of the year were net losers.
Therefore, unless you already own shares of AGG and want to hold them for the long term, it is worth reading further before investing.
Why invest in FLOT
Conventional wisdom dictates that you only buy floating rate bonds when you expect interest rates to start rising. However, there have already been so many and rates have already risen six times, as shown in the chart below, and are now at 3.83%.
Now, after being lifted so many times in quick succession, some markets attendees question the justification for further hikes given that inflation is mainly supply driven.
Now, based on the negative effect of monetary policy tightening on economic growth, you don’t have to be an economist to predict what lies ahead. One option is a Fed pause. Another is that even if there is no pause, it can reduce the rate at which it increases, for example from 75 basis points to 50. This would be great for risky assets like stocks and bonds at all levels.
In this regard, the speeches delivered by Fed Chairman Powell have been variously interpreted based on key economic indicators such as the consumer price index and employment figures. Some dovish interpretations even elicited enthusiastic market reactions in July this year, but as the chart above shows, this has by no means deterred rates from rising, suggesting that the interpretation may s prove futile.
Yet the lessons have not been learned as Chairman Powell’s final speech after the Fed raised rates by 75 basis points in the first week of November is interpreted by some market participants as a “timid dovish pivot.” However, according to the table below, history teaches us that interest rates can go much higher, as in the period 2007-2008.
Thus, they can even go above 5%.
Moreover, in addition to the direction of future movements in interest rates and the rate at which they increase, it is also important to consider terminal rates, as they determine other benchmarks such as mortgage rates. To that end, Larry Summers, a former Treasury Secretary famous for successfully predicting that inflation would not be transitory in December 2021, nor faster than the Fed itself, said the terminal rate would be 6%. . This means that there is still some way to go, which is favorable for FLOT while being detrimental to AGG.
Interestingly, that 6% prediction he made a few days ago is higher than his previous prediction of 5.5% made on November 1. The reason for the upgrade is due to factors such as the October jobs report and the strength of the US economy. However, this move from 5% to 6% shows that economic conditions are very dynamic and can quickly change in the other direction, prompting economists to revise terminal rate expectations downwards.
Reasons to also consider AGG
So, while interest rates still seem to be rising, which means investing in FLOT makes sense, consider that the Fed could become dovish in the event of a sudden deterioration in economic conditions. In this case, depending on liquidity conditions, investors will likely seek the safety of AGG’s higher quality assets. So, given the trend of rising interest rates on the one hand and deteriorating economic conditions on the other, it is better to consider both AGG and FLOT.
For illustrative purposes, price performance, as well as investment results over a ten-year period, are shown in the table below, with each row corresponding to a specific period with a $1,000 investment made. in FLOT and AGG respectively.
Going into detail and looking at the price performance, investors will notice that FLOT has relatively outperformed AGG for every period beginning in November 2012. Thus, $1,000 invested in the floating rate ETF suffered from a depreciation of the capital less than an equivalent amount invested in basic bonds. .
This means you get better capital appreciation through floating rates. Equally important, when interest rates fell sharply between August and November 2019 (as shown in the chart below), FLOT stock price still managed to clear 0.15% while AGG outperformed by 1.57% over the three-month period.
Now, a major difference between 2019 and 2022 is the stickiness of inflation, which means the Fed is unlikely to cut interest rates sharply like five years ago.
Therefore, with interest rates unlikely to fall sharply except in a recession, FLOT, which captures the benefits of rising rates, should not suffer too much as inflation remains consistently high. As for AGG, prices may not have bottomed, but it pays higher dividend yields, as shown in the chart below, and also charges lower fees. Therefore, over a long period, AGG can offer better total returns, which include price performance and dividends in case these are reinvested.
Given these factors, it would make sense to split your investment between fixed and floating. To that effect, the price performance chart above shows that a combined AGG-FLOT portfolio consisting of an initial investment of $2K split equally between the two ETFs performs better than a portfolio consisting exclusively of $2K of AGG shares over all time periods.
Finally, both ETFs see entries like AGG and FLOT get A- and B grades respectively, but things could change quickly, depending on economic indicators or how the market interprets Jerome Powell’s speech at the next FOMC meeting on December 13 and 14.