One of the biggest questions that the market has been facing in the past few months relates to the Fed’s scaling down of its bond purchase program. Conflicting statements from the Fed officials have only added to the uncertainty. However despite uncertainty related to the actual timing of the start of tapering—whether it would be September, December or even sometime next year—investors have certainly started preparing for the ‘post-QE’ world.
In anticipation of the imminent tapering, interest rates have been inching up. Though the 10 year yield has come down from a high a 2.75% reached in early July, it is still very high compared with a low of 1.61% reached in early May this year. (Read: 3 Sector ETFs to profit from Rising Rates)
Investors worried about the imminent rise in rates have been dumping long-duration bonds and bond funds. But the fund flows shows that while investors are cashing out of longer term bonds, they are not yet ready to put that money into stocks; they have instead put that money as cash or into short-term and floating rate bond funds.
While long-term bond ETFs including investment grade (LQD) and high yield (JNK) were among the top ten asset losers, short-term bond ETFs like SHV and BSV and senior loan ETFs BKLN have been among the top gainers this year. (Read: 3 Sector ETFs to avoid as rates rise)
Some investors have bet on rise in interest rates by using inverse bond ETFs and have also profited from such strategies. Such investors need to keep in mind that leveraged and inverse ETFs are not meant for long term holding as they are designed to achieve their objectives on a daily basis and also because of their usually higher expenses.
Below we have analyzed three ETFs that investors could consider in the rising rates environment. (Read: Best ETFs from the market’s top sector)
PowerShares Senior Loan Portfolio )
Senior loans are secured by company’s assets and are thus lower in risk structure, even though these loans are mostly issued by companies with below investment grade credit. These are floating rate loans so they usually pay a spread over some benchmark rate like LIBOR. Thus, in the event of rise in interest rates, coupons on senior loans increase while the value of the investment remains stable. On the other hand, bonds lose value if the interest rates go up.
So, investors in senior loans or in senior loans ETFs get the benefit of high yields with protection against any interest rate rise. Further, they carry lower credit risk compared with most other assets with similar level of yield. Additionally senior loans have low correlations with other asset classes.
BKLN is based on the S&P/LSTA U.S. Leveraged Loan 100 Index which is designed to track the largest institutional leveraged loans based on market weightings, spreads, and interest payments.
The ETF currently holds about 131 securities in total. With most of these holdings maturing between one and ten years, the fund has years to maturity at 5.18. In terms of credit rating, about 42% of the holdings are “BB” while 44% are ranked "B" by S&P.
The product is slightly expensive with an expense ratio of 66 basis points a year, but it pays out an attractive dividend yield of 4.62% at present.
The ETF was launched in March 2011 and has managed to attract about $5.1 billion in assets so far. The volume is generally very high, giving the fund an extremely low bid ask spread.
iShares Floating Rate Note Fund
Launched in June 2011, FLOT tracks the Barclays US Floating Rate Note less than 5 Years Index. The index comprises US dollar denominated investment grade floating rate notes with a remaining maturity of greater than one month and less than five years.
The variable coupon for the notes in the index is equal to an aggregate of 1/3/6 months LIBOR rate plus a fixed coupon spread depending on the credit risk of the issuers.
The fund currently holds 290 notes with a weighted average maturity of 1.8 years. The ETF charges a low 20 bps in annual fees from investors. The product has seen an impressive asset inflow this year, pushing its asset base to $2.6 billion. With just 13.6% of the asset base in top ten holdings the fund is very well diversified, limiting the default risk of any individual issue.
iShares Short Treasury Bond ETF (SHV)
The product that made its debut in January 2007 now has a massive $4.6 billion in AUM. It holds 17 securities as of now.
The fund has a weighted average coupon of 1.45% and an effective duration of just 0.45. It charges only 15 basis points in expenses, lower than the category average of 23 basis points.
This product is suitable only for investors looking for ‘ultra-safe’ investment, which can add some diversification benefits to their equity portfolio. It can also be a substitute for money market funds. Investors looking to ‘park’ their cash for some time before they decide where to invest could consider this fund.
Further, investors may prefer short duration ETFs to money market funds, in view of some of the SEC’s proposed reforms.
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