Today's Free Feature

Briefing.com Summary:

*TFLO offers capital preservation, monthly income, and minimal duration risk in a higher-for-longer rate environment.

*TFLO’s low equity correlation and Treasury backing help reduce portfolio volatility during uncertain market conditions.

*TFLO provides defensive positioning while still allowing investors to benefit from elevated short-term interest rates.

The market cap-weighted indices have roared to record highs, so what is the next play for active investors? There are a lot of recommendations, and one we'd like to suggest is to just go with the flow.

An important distinction is that we don't mean go with the flow of the stock market, although that may end up being related. No. We mean go with the flow of the iShares Treasury Floating Rate Bond ETF, which is earmarked with the symbol TFLO.

Playing Offense with Defense

We have rising stock prices right now, but we also have rising interest rates. The stock market hasn't been thrown off by the rising rates (yet), but when it comes to rising rates, they throw off more income for TFLO, whose holdings—U.S. floating rate Treasury bonds—benefit from interest rate payments adjusting to reflect changes in interest rates.

TFLO, then, has both defensive and offensive characteristics in a rising interest rate environment. It isn't typically described in that manner. The typical designation is that it is a capital preservation play in a rising interest rate environment. That is its defensive element.

Where the offensive element comes in is that TFLO offers investors a way to capitalize on higher rates that may ultimately leave the stock market on the defensive and cash under-earning. It is a nuanced distinction of playing offense with defense, and it is likely to be a game worth playing if inflation keeps rising and market rates follow.

A Dramatic Shift

The 2-yr note yield is up 52 basis points this year to 3.99%, while the 10-yr note yield is up 31 basis points to 4.48%. Those moves are a reflection of the economic resilience and inflation pressures that have pushed out expected rate cuts by the Fed.

When the year began, there was a prevailing view that the Fed would cut the target range for the fed funds rate twice before the end of the year. That expectation has been washed away.

According to the CME FedWatch Tool, there is a stronger probability that the next policy move will be a rate hike as opposed to a rate cut. Specifically, there is a 52.3% probability of at least a 25-basis point hike in the target range to 3.75% to 4.00% at the March 2027 meeting. In fact, the fed funds futures market isn't even expecting a rate cut in 2027 now.

Why has this outlook shifted so dramatically? It boils down to the dual mandate of maximum employment and price stability. The former is holding serve for the most part, whereas the latter has triple faulted.

• Employment gauges are closer than not to maximum employment
  • The unemployment rate is 4.3% (the Fed's longer-run estimate is 4.2%)
  • The 4-week moving average for initial jobless claims is just 203,250, a low level typically associated with a strong labor market
• Inflation gauges remain well above the Fed's 2.0% target.
  • CPI +3.8% yr/yr; core CPI +2.6% yr/yr
  • PCE Price Index +3.5% yr/yr; core PCE Price Index +3.2%
  • PPI +6.0% yr/yr; core PPI +5.2%

Floating Some Thoughts

A product brief from iShares describes Treasury floating rate notes as U.S. government bonds with coupons that periodically reset using 3-month T-bill rates. Specifically, coupons are based on the highest accepted discount rate of the most recent 13-week T-bill auction, which occurs each Monday, plus a fixed spread.

They are issued with a two-year maturity and represent approximately 2.3% of the total market value of marketable U.S. Treasury debt. The weighted average coupon for the portfolio is 3.80%.

Yields will change on floating rate notes as the Fed adjusts the target range for the fed funds rate. Part of TFLO's appeal today, then, is the prevailing expectation that the Fed won't be lowering the target range for the fed funds rate anytime soon and may even raise it within the next 12 months.

A lot can happen between now and then, but if you are on board with the idea that rates are going higher or staying higher because inflation is sticky, TFLO offers an opportunity to manage that interest rate risk with its short duration.

There is also very low credit risk with TFLO since it owns U.S. Treasury floating rate notes, which are backed by the full faith and credit of the U.S.

Don't expect much from this fund in the way of total return. Its main draw is capital preservation in a rising interest rate environment that is augmented by its low correlation to stocks (3-yr equity beta 0.00) and low expense ratio (0.15%).

Another draw is that TFLO distributes income monthly, so it provides a regular cash flow stream. The trailing twelve-month distribution yield is 3.96%.

Primary risks for this ETF include the Fed cutting rates aggressively, high inflation rates that erode real returns, and reinvestment risk in a declining rate environment.

Briefing.com Analyst Insight

In a market environment where elevated valuations, sticky inflation, and rising interest rates are all competing for investors' attention, TFLO offers a compelling alternative for those looking to preserve capital without leaving cash entirely idle.

It is not a high-octane return vehicle, nor is it meant to compete with aggressive equity exposure during a bull market. Rather, it is a strategic allocation for investors who believe the Fed may need to keep policy restrictive longer than currently appreciated and who want income that can adjust with that reality.

The stock market may continue climbing, but if higher rates eventually pressure valuations, TFLO provides a way to stay invested while reducing both duration risk and equity market sensitivity. In that sense, TFLO represents a rare blend of defense and opportunity: a capital preservation tool that can still benefit from a higher-for-longer interest rate regime. For active investors navigating an uncertain macro backdrop, going with the TFLO may not be such a bad play.

--Patrick J. O'Hare, Briefing.com