TFLO ETF: Still Some Juice Left To Squeeze From This Yield (NYSEARCA:TFLO)
Short-term rates have rallied strongly in 2022. Many asset classes suffer from higher rates, but among those that benefit are floating rate securities, including the iShares Treasury Floating Rate Bond ETF (NYSEARCA:TFLO). This fund invests in U.S. Treasury Floating Rate Notes (FRN). FRNs are a two-year note that pays interest on a combination of a floating index rate and a spread rate assigned at issuance. The index rate for FRNs is the 13-week Treasury Bill rate, adjusted weekly.
TFLO distributes the interest earned on holdings to its shareholders in a monthly dividend. The dividend has been increasing as the 3-month (13-week) Treasury rate has increased. The latest dividend payment was $0.099 per share, which is annualized at 2.35%.
Floating rate notes have been very popular as of late. Asset flows for TFLO has been incredible with AUM increasing 1,111.81% YoY. Average daily share and dollar volume is very high at over 20x other ETFs. The market is strongly in favor of these investment vehicles.
I also have a large position in TFLO and Floating Rate Notes. As long as short term interest rates continue to rise, these instruments will continue to perform attractively. But this thesis will change when rates begin to decline. I do not expect that to occur in 2022, but I think it is coming.
Yields will Continue To Rise
TFLO has returned a total of 1.22% year to date. This return is meager, but could nearly double within a matter of months. This is because the yield on the 3-month T-bill has rallied strongly and is due to continue.
TFLO has a 30-day SEC yield of 3.16% and an average yield to maturity of 3.85%. Therefore, I expect dividend payments of $0.13-0.16 through the end of the year at current rates and if the 3 month continues to rise those distributions will increase. Because TFLO is a floating rate ETF, it has a convexity of 0.00 with average weighted maturity of 0.53 years. This offers shareholders a flexible and risk-attractive return.
In addition, the fund has 27.33% of holdings maturing on October 31, 2022. This FRN issuance has a spread of 0.055%. The October 31, 2022 FRN issuance has a spread of 0.140%, therefore the fund will receive a small increase in yield after reinvestment.
Rates Will Go Higher, Until They Don’t
In the near term, expectations are high for short term rates to increase. The September FOMC Dot Plot, which has a checkered forecasting record, is expecting the Fed Funds Rate above 4.25% by the end of 2022 and above 4.5% in 2023. If true, this would prove to be supportive of FRNs.
Here’s the rub. The market is beginning to temper expectations for further rate hikes. The 3-month T-bill is already at 4% which only leaves 50 basis points of runway if the Fed’s target is to be reached. For now, the market expects that to occur, with the CME FedWatch Tool projecting a 95% probability that the FFR is above 4.25% by the December FOMC meeting. But for March 2023, the tool has dropped the probability of an FFR above 5% from 53% a week ago to 29.6% today.
I recently wrote about why this is occurring. This is what I said:
The Wall Street Journal Chief Economics Correspondent Nick Timiraos published an article that suggested a change in Fed policy may be in progress.
Yield curve inversion tends to precede a pause in rate hiking and the start to rate cuts. Of the three we have examined, currently one and a half have inverted. If history is a guide, we are near a policy stance pivot but not quite there yet.
No sooner did my article publish that the 10Y-3M yield inverted again. This yield curve inversion serves as a guide for economic analysis and policy direction. The last three times this yield curve inverted, the Fed paused rate hikes almost immediately and began cutting rates shortly thereafter. In 2000, it took about 183 days for rates to fall from the time the curve first inverted. In 2006-07, it took about 546 days. In 2019, it took about 30 days. Given this historical context, I am expecting a pause of rate hikes in 2023.
Floating Rate Notes are due to continue to benefit from rising rates over the coming few months. That is beneficial for the TFLO fund and its investors. The ETF is poised to deliver 3-4% dividends through the end of 2022 and potentially 4-5% dividends in 2023.
But lower expectations for additional rate hikes and yield curve inversions are signaling that the end of rate hiking is slowly approaching. The setup is strong for a pause of rate hikes in 2023. That will be a signal that the juice has been squeezed from this yield, and it will be time to look elsewhere.