VRIG - VRIG: Stay Tuned For A Potential Fed Pivot

2023-03-20 15:18:25 ET

Summary

• VRIG provides a resilient shield to bond price volatility.
• Interest rates are looking like they are approaching an inflection point. However, the +25bps scenario is still on the table.
• The storm is not blowing over yet, so brace for a pivot while staying on with VRIG.

The golden period for instruments that give investors insurance against rising interest rates is in full swing. The global debt market used to be in a dense red zone, while the recent turbulence in the financial sector following the failure of SVB changed the market expectation on the interest rate path. However, the resilient economic data suggests that the Fed is not done with its intention to slow down the US economy, and is still ready to raise the key lending rate.

At the same time, it is apparently not necessary to say that the prospects for further normalization of the interest rate policy by the leading central banks are already fully incorporated into the current bond prices. Not only is there no confidence in the terminal level of base rates, but the outlook for inflation is not fully clarified, which matters to the pricing of long-term bonds. The issue of interest rate risk can be solved using instruments with a built-in hedging mechanism against interest rate volatility - variable rate instruments, which are the main focus of the Invesco Variable Rate Investment Grade ETF ( VRIG ). With a duration tilted to zero, the VRIG is immune to the interest rate risk and should allow its holders to feel confident in the period of rising rates.

In the context of tightening of monetary policy, interest rate risk has become a real pain for debt market participants. Another scourge for investors is inflation, which is at high levels. It should be noted that interest and inflation risks are intertwined for debt instrument holders in the sense that they face additional losses due to the fact that, in search of higher yields, they are forced to lengthen the duration of their portfolios. Apparently, it is necessary to look for instruments that would be characterized, on the one hand, by minimal interest rate risk, and, on the other hand, could offer their holders a potential for some positive real return. And without moving into the non-investment grade category, I find holding of VRIG shares still prudent.

Overview

The Invesco Variable Rate Investment Grade ETF, which, as the name suggests, tracks floating rate bonds with investment grade credit ratings. The fund retains 96% of its portfolio in securities with ratings not lower than BBB-, which helps ensure the stability of the fund's performance indicators.

As you can see in the chart above, compared to the SPDR Blackstone Senior Loan ETF (SRLN), VRIG shows much less volatility. While VRIG returns have hovered around zero for a year, this is in stark contrast to the losses experienced by bondholders. Not to mention the US banks, which are sitting on more than $600 billion in unrealized losses.

Most of the VRIG holdings are floating rate bonds, so if interest rates climb, their yields will gradually follow suit. This results in the fund having a duration of only 0.05 years (5 days), which means that for every 1% rise in interest rates, there would be a 0.05% decrease in the fund's performance. VRIG is focused on generating current income, i.e. dividends that are paid monthly, and it should be noted that the dividend payments have increased substantially since the same point last year due to the permanent increase in coupon rates, which are periodically reviewed following the reference rates for portfolio securities. Thus, the weighted average coupon increased to 5.48% from 3.85% half a year ago. At the same time, its further growth is not ruled out, as the cycle of rate hikes has not ceased.

The share price of VRIG has been on an uptrend since November last year. However, in light of the recent bank failures and expectation of the Fed easing interest rates, the fund backed up. The futures quotes are not pricing in the +50bps scenario at all, which is reflected in the following chart.

The fund registered a net outflow of $47.3 million so far in March, which erased the net inflows since the beginning of the year to $2 million. Clearly, investors are shifting their focus of preserving their money from interest rate hikes to more attractive investment opportunities in the anticipation of the potential Fed pacification. In the meantime, there is a prevailing probability of a +25bps scenario , which could effectively postpone the timing of the above switch.

To assess the potential return, let's take into account the following. The weighted average coupon on the portfolio is currently 5.68%. The fund's current distribution rate is 5.32% and the management fee is 0.30%. As a result, it is quite reasonable to expect a 5-5.3% return over the next 12 months.

Conclusion

I would stay Hold with VRIG shares, as the ETF allows investors to protect themselves from interest rate risk, which, apparently, will remain at an elevated level in the medium term. In addition to the protection of price stability, the fund's bond portfolio brings coupon income, the value of which is on an upward trend against the backdrop of rising interest rates. VRIG is an investment in highly reliable instruments with the highest ratings, which can be considered as a kind of safety cushion, given the low credit risk.

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