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With the Federal Reserve's first interest rate hike looming, advisors are likely engaging in evaluation of asset classes that are believed to be durable as borrowing costs rise.
As advisors know, this is a particularly important endeavor in the fixed income space, meaning the importance of this task is amplified for advisors that have large amounts of older clients or those nearing retirement.
Fortunately, the list of fixed income segments that can be durable when rates rise is surprisingly robust. It's often a matter of looking beyond the most prosaic areas of the bond market and embracing some concepts that some clients may not be familiar with. That includes floating rate notes (FRNs).
Still, clients are being pinched by rock-bottom yields on municipal bonds and Treasuries while credit spreads are depressed, indicating the reward for taking on risk above Treasuries isn't what it used to be.
Ominous as all that is, the current fixed income and interest rate landscape is conducive to advisors adding value for clients by introducing them to bond assets they may not be familiar with, including FRNs.
Why FRNs Are Worth Considering
Good news for advisors (and clients): FRNs are easily accessible via an array of exchange traded funds including the VanEck Investment Grade Floating Rate ETF (FLTR), which tracks the MVIS US Investment Grade Floating Rate Index. FLTR is an efficient avenue to gaining the benefits of FRNs.
“Because FRN coupons reflect current interest rates, the price of the bonds are not sensitive to changes in rates,” says William Sokol, VanEck senior ETF product manager. “This is in contrast to fixed rate bonds in which the coupon does not change with interest rates but the price will increase/decrease as rates decline/increase. As a result, FRN prices have near-zero sensitivity to interest rates and coupons will actually increase as rates go up, making them potentially attractive in rising rate environments. In other respects such as credit risk, they are similar to other bonds from the same issuer.”
Home to nearly $840 million in assets under management, FLTR holds 212 bonds. One thing advisors will have to make clients aware of with FLTR or any other floating rate fund is that, for the most part, yields are low with investment-grade FRNs.
Articulate it to clients in terms of there never being a free lunch in financial markets. If an investor is looking to mitigate rate risk in the bond space, chances are that investor will have to accept low yields. Conversely, the investor willing to take on rate risk (or credit risk) will be compensated with higher yields. For its part, FLTR yields just 0.38%.
Still, FLTR has some perks that are relevant to clients.
“Further, FLTR’s index is designed to provide an enhanced yield versus the broader FRN universe. This is done in two ways,” adds Sokol. “First, FLTR’s index focuses on corporate FRNs only, and does not include non-credit issuers such as the U.S. Treasury and government agencies. This results in a higher average spread and a higher overall yield versus the broad market. Second, FLTR’s index re-weights constituents so that there is a higher weight towards longer maturity bonds.”
Prime Protection Against Rising Rates
Of course, past performance isn't a guarantee of future returns, but it's hard to ignore FLTR's track record. For the 10 and a half year period ending Dec. 31, 2021, FLTR ranked in either the first or second quintile of domestic ultra-short term bond funds and always topped the category average.
And then there's the aforementioned protection against the Fed's renewed hawkishness.
“As a result, prices have virtually no sensitivity to changes in interest rates. Investors will not suffer mark-to-market losses as interest rates rise, but will also not benefit from interest rate declines. This is in contrast to fixed coupon bonds, which will exhibit a sensitivity to interest rates that is measured by interest rate duration. Longer maturity bonds have longer durations, all else equal,” adds Sokol