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Those not living under a rock by now that on Wednesday, the Federal Reserve raised interest rates by 25 basis points. From here, the question is how many times will the central bank raise rates this year.
Following the rate increase, some experts said the Fed could raise rates as many as six or seven more times this year and that's saying something because the next meeting of the Federal Open Market Committee (FOMC) is in May.
In other words the rising rates environment advisors and clients have long dreaded is here, it could drag into 2024 and that's likely to being trying for portfolios that are currently heavily tilted to bonds. Fortunately, advisors know that Fed tightening won't doom all corners of the bond market. Take the case of floating rate notes (FRNs).
Owing to the fact that FRN coupons reflect current interest rates, the prices of these bonds aren't overly sensitive to interest rates.
Why Floaters Are Fantastic Now
A big source of the allure of FRNs in rising rate environments is low duration. For example, the VanEck Investment Grade Floating Rate ETF (FLTR), which tracks the MVIS US Investment Grade Floating Rate Index, has a duration of just 0.03 years. That's ultra-short term.
Reducing duration, seeking enhanced yields and targeting less correlated segments of the market are all ways to build a more resilient bond portfolio in the face of rising rates and higher than average inflation. Investment grade floating rate notes (“FRNs”) may be an attractive way to balance these goals and allow investors to protect against rising rates while actually increasing their income as rates go up,” says William Sokol, VanEck senior ETF product manager.
Something else advisors know – and it's worth mentioning in client conversations – is that the bond market epitomizes the notion that are no free lunches in financial markets. Want a higher yield? You'll have to take more credit or rate risk. Want to eliminate or mitigate those risks, you're going to get a lower yield.
In the case of the aforementioned FLTR, rate risk is essentially non-existent and credit risk is minimal, meaning the fund doesn't sport a big yield. As such, it needs to outperform other fixed income assets when rates rise. It appears that's happening this year.
“Indeed, FRNs have performed well year-to-date through February 28 in the face of rising rates, with returns that are apprsoximately flat versus a -3.3% loss in the broad U.S. market (as measured by the ICE BofA US Broad Market Index) and -5.2% among fixed rate corporate bonds (as measured by the ICE BofA US Corporate Bond Index),” adds Sokol.
Still, FLTR does have some income proposition because unlike many floating rate funds, this ETF is dedicated to corporate debt. It holds no government issues. Second, its holdings are mostly longer maturity, which boosts the ETF's income profile a bit.
“Even in the ultrashort, high quality segment of the market, however, there are ways to enhance income. For example, focusing on credit-oriented issuers like corporates, rather than sovereign and agency issuers, can increase the spread and, therefore, overall yield,” adds Sokol.
Fine Idea
If we were in a declining rate climate, floaters wouldn't be advantageous for clients, but that's not the current reality.
Additionally, floaters offer the perks of decent income and diversification while obviously being barely correlated to rate-sensitive corners of the bond market.
“Further, this is achieved without adding significant credit risk since the bonds carry investment grade ratings,” concludes Sokol. “This is in contrast to leveraged loans, another floating rate asset class, which provide higher yields but with much higher credit risk. With the uncertainty that has impacted the market recently, many investors may find the relative safety of FRNs desirable.”