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With the rapid expansion of the ETF industry, products have cropped up in a variety of sectors that can give investors exposure to new asset classes. One such space that has seen a great deal of interest from some is in the bond space with floating rate securities. These funds track bonds that do not pay out a set rate to investors but instead have variable rates that are often tied to an underlying index such as LIBOR. As a result, bonds that employ this approach can have different yield rates than their fixed rate cousins, potentially giving them a unique risk/reward than their more ubiquitous counterparts (see Top Three High Yield Bond ETFs).
This could be important given the state of interest rates and the direction that they will have to go in years ahead. With the benchmark rate at 0.25% in the U.S., many feel that a normalization of interest rates will have to take place in the near future, potentially crushing the long-term bull market in bonds in the process. However, for investors who have floating rate securities, the blow is likely to be much less severe. This is because floating rate securities have a far lower interest rate sensitivity than their fixed rate brethren, making them ideal choices in rising interest environments.
Downsides of floating rate bond ETFs
While there may be several positives for this corner of the market, investors should realize that ‘floaters’ aren’t the be all end all in the bond space. First, it is important to remember that we are still in a low interest rate environment and that higher rates may not be coming down the pike for several years. This could keep bonds that pay out a variable rate depressed in yield terms when compared to their fixed rate counterparts for the foreseeable future, taking away one of the key selling points for the product class. Furthermore, because floaters have less of a demand from the general investing public, there are less of these bonds in the market place suggesting that any fund tracking a basket of these securities will only have but a handful of different companies. If that wasn’t bad enough, most securities that issue this type of bonds are financials, meaning that the product will likely see heavy concentrations in that particular sector over the long haul (Can You Fight Inflation With This Real Return ETF?).
Yet despite these short-term negatives, a case for floating rate bonds over the long term can still be made. Most investors are intensely concentrated in U.S. government debt and with yields at historic lows, a reversal seems poised to strike the market at some point in the future. So while in the near-term floating rate bonds may underperform similar fixed securities, they could make for a nice compliment to fixed rate-heavy portfolios for investors with more than a few years until retirement. For these investors, any of the following three ETFs could make for excellent choices:
This relatively new fund tracks the Barclays Capital US Floating Rate Note Less Than Five Years Index which gives investors exposure to a basket of bond securities that have floating rates. The total portfolio consists of 133 securities but close to 53% of the assets go towards financials. The fund does have a pretty low expense ratio, charging investors 20 basis points a year, a figure that is more than made up for by the fund’s 1.7% 30 Day SEC Yield. In terms of performance, the product has lost about 2.3% since inception although it has stabilized in recent weeks (read Go Local With Emerging Market Bond ETFs).
The oldest product in the floating rate ETF space is this fund from Van Eck. The fund seeks to replicate the Market Vectors Investment Grade Floating Rate Index which is a benchmark that consists of U.S. dollar-denominated floating rate notes issued by corporate issuers and rated investment grade by at least one of the three major rating agencies. In terms of holdings, the fund has just 23 securities in its basket putting close to one-fourth of the total in bonds from Credit Suisse and Citigroup. While the product does beat out FLOT in terms of expenses by a basis point, its yield is far worse coming in at 1.1% when measured by the 30 Day SEC yield metric. The product has also underperformed on the capital appreciation front as well as this floating rate ETF has lost about 7% in the past six months (see Australia Bond ETF Showdown).
The newest fund on the list, FLRN debuted at the end of November giving investors a very short window into its performance history. Yet, with that being said, FLRN does track a similar index to FLOT suggesting that the performance could be near what that security has produced. Investors should note, however, that there are a few key differences between the two. First, FLRN only holds about 50 securities in its basket while charging an expense ratio of just 0.15% a year, putting it lower than FLOT for both. Fortunately, FLRN does beat out FLOT in terms of yield, as the fund pays out close to 2% a year, thanks to its heavier focus on securities that are a few years away from maturity and (as opposed to the other products which have a slightly greater tilt towards short-terms bonds).
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