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The recent economic slowdown in the developed and emerging nations has forced the domestic U.S. interest rates to plummet near all time lows. A ‘safe haven’ sentiment among the market participants and other investors has caused them to withdraw funds from risky assets and park them in safer securities such as U.S. Treasury bonds. Thanks to this, the 10 year Treasury bonds currently yield around 1.60% while the long dated 30 year Treasury bonds trade near 2.67% (read Forget European Woes with These Three Country ETFs).
Not only has this caused a downward pressure on the benchmark rates, but it has also resulted in appreciation of the U.S. Dollar (USD) against other major currencies. In order to strike a balance between growth and inflation in these difficult times, the Federal Open Market Committee (FOMC) has been pretty much following an ultra-low interest rates policy, and looks to continue this for at least this year (read ETF Trading Report: 3-7 Year Bond, Small Caps In Focus).
This is best demonstrated by the recent extension of ‘Operation Twist’ (in order to further decrease long term borrowing costs) which looks to cycle short term bonds for longer dated ones. Furthermore, in the FOMC’s recent two-day meeting, sentiment suggested that rates look to remain depressed into the future, especially given how uncertain the current economic outlook is around the globe.
Choices for income seeking investors
At a time like this, investors seeking current income (especially bond investors) are left with very little choice to play with. Due to the ultra-low yields, bond prices have significantly appreciated. Therefore investing in bonds would surely result in erosion of invested capital once interest rates start rising.
However, a variety of investment avenues, especially from the ETF space, might be of particular interest to these investors. Preferred stock ETFs offer a hybrid exposure for income seeking investors and also scope for capital appreciation. Many products from the preferred stock ETF space pay out attractive yields and have performed well in the face of the weak economic environment (see Complete Guide to Preferred Stock ETF Investing).
The iShares S&P U.S. Preferred Stock ETF (PFF) pays out an annual yield of 6.02% and has returned 11.04% year till date in terms of total returns. The PowerShares Financial Preferred ETF (PGF) has an impressive asset base of $1.64 billion and sports a yield of 6.93%. In terms of total returns the ETF has returned 13.95% year till date.
Emerging markets generally have superior interest rates than most developed nations. Therefore, for investors seeking international diversification along with high levels of current income, Emerging Market Dividend ETFs provide an excellent opportunity. Moreover, the brief broad market slump last fiscal for many of these nations have effected good valuations, thereby offering substantial scope for capital appreciation (read Top Three Emerging Market Dividend ETFs For Income And Growth).
The WisdomTree Emerging Markets Equity Income ETF (DEM) pays out a solid yield of 4.49%. SPDR S&P Emerging Markets Dividend (EDIV) also pays out an impressive 5.02% in annual yields. However, DEM and EDIV have slumped 2.56% and 6.59% on year-to-date basis.
However another asset class that could provide a good opportunity for income seeking investors that are looking to stay in the bond world with minimal duration risk; floating rate bond ETFs.
Floating Rate Bonds explained
Floating rate bonds (also known as floaters) are basically bonds with variable coupons. These coupons are reset at a predetermined date and are indexed to a particular benchmark rate. (i.e. London Inter Bank Offer Rate or LIBOR or U.S 10 year Treasury Bond, etc.) plus a variable premium. This variable portion of the coupon is usually based on the credit rating of the issuer.
At the time of interest payment, the effective coupon would be equal to, the benchmark/reference rate quoted at the previous interest payment date plus/minus the premium/discount.
What sets these bonds apart from other plain vanilla debt instruments is that a significant portion of the interest rate risk is nullified by the change in coupons (i.e. variable coupon rate). Therefore, holders of these instruments are protected from a significant capital erosion resulting from an increase in general interest rates.
Risks and Drawbacks
While these bonds usually go a long way in reducing interest rate risk, they still are subject to credit risk of the issuer. Therefore if the issuers go belly up, technically the bond holders face the risk of losing all of their invested capital.
The coupons associated with these bonds are generally lower that most traditional fixed income securities. Moreover, while these bonds prevent against losses, the flip side also holds true—they even restrict the upside. However, given the current economic conditions and low interest rate scenario, investors could be much better off playing the floating rate bond portfolio than the more traditional bond segment.
iShares Floating Rate Note (FLOT)
Launched in June 2011, FLOT is a floating rate bond ETF which tracks the Barclays US Floating Rate Note less than 5 Years Index. The index comprises of floating rate notes issued by various institutions. The notes in the index are investment grade and have a residual maturity ranging from a month, to five years.
The variable coupon for the notes in the index is equal to an aggregate of 1/3/6 months LIBOR rate (i.e. reference rate) plus a variable spread depending on the credit risk of the issuers. The ETF has a weighted average maturity of 1.72 years and presently holds 207 notes issued by various institutions. The ETF pays out a yield of 1.17%. Presently the 1/3/6 months USD LIBOR rates are 0.24525%, 0.46060%, and 0.73440%, respectively. (read PIMCO Files For Three More Active Bond ETFs)
As far as credit risk is concerned, the ETF can be considered a relatively safe option for investors as the fund gets an overall credit rating of A+ by S&P which means Strong capacity to meet financial commitments, but somewhat susceptible to adverse economic conditions and changes in circumstances.
Also, an effective duration of 0.12 years signifies negligible vulnerability to interest rate risks. The ETF charges a paltry 20 basis points in fees and expenses and has managed to witness an impressive inflow in its asset base. It has total assets of $199.24 million.
SPDR Barclays Capital Investment Grade Floating Rate ETF (FLRN)
The ETF seeks to replicate the performance of Barclays Capital U.S. Dollar Floating Rate Note less than 5 Years Index. The Index measures the performance of floating rate notes which are U.S. dollar denominated and uses the 3 month LIBOR as the reference rate. The ETF debuted in December of 2011 and since then has managed to attract a moderate asset base of $9.10 million.
The ETF charges just 15 basis points in fees and expenses and, on an average, 12,080 shares of FLRN are traded each day. The weighted average maturity of the ETF is 1.42 years and currently it is sporting a yield of 0.84%. An effective duration of 0.11 years and 0.00% convexity suggests that the ETF is pretty much immune to interest rate risk.
FLRN holds 102 securities presently and has a modest bid-ask spread of 3.53%.
Market Vectors Investment Grade Floating Rate ETF (FLTR)
FLTR tracks the Market Vectors Investment Grade Floating Rate Bond Index which measures the performance of investment rate floating rate bonds that are issued by U.S. firms as well as global corporates. The product was launched in April 2011 and has total assets of $7.27 million. The ETF lacks popularity as indicated by an average daily volume of 1,848 shares.
FLTR has comparatively high weighted average maturity of 2.90 years and average modified duration of 2.75 years. Therefore it is more sensitive to interest rate movements than most of its counterparts. However, it charges a low expense ratio of 19 basis points and has an average yield of 0.94% making it among the best in the space for these two metrics.
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