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3 ETFs to Watch on Rising Rates

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The biggest uncertainty in the stock market over the past several months is the actual timing of the first interest rate hike in the U.S. since 2006. The Fed is on track to raise interest rates later in the year given the strengthening domestic economy and better job prospects.

In the latest FOMC meeting, Janet Yellen highlighted the procedure for rate-setting policies in the coming months. First, the Fed will remove the word ‘patient’ from its statement in describing its approach to rate hikes, and then raise interest rates when warranted at any meeting. This suggests a possible mid-year rate increase while at the same time provides flexibility to the Fed to wait longer if the labor market falters or inflation does not pick up (read: Rising Interest Rates Are Great News for These Bond ETFs).

The latest job data for February suggests sooner-than-expected rate hikes. This is especially true as the economy added 295,000 jobs in February, far above the market expectation of 235,000 and sustained the pace of hiring of over 200,000 jobs for the 12th month in a row. Notably, 2014 was the best year for job growth since the late 1990s.

Unemployment dropped to 5.5%, the lowest rate since May 2008. Average hourly wages of $24.78 rose modestly  by 3 cents in February and 48 cents over the past 12 months. The solid job data fueled expectations that unemployment would fall further and inflation might pick up. In anticipation, interest rates have been inching up. The yield on the 10-year Treasury bond has risen 33% in the past five weeks (ending March 6), representing the sharpest 5-week increase in 20 years.

While investors are dumping long-duration bonds and bond funds, there are still a number of compelling choices in the fixed income ETF world in this rising rate environment. Some of these are senior loan funds, floating rate funds, and zero or negative duration bond funds. Below, we have detailed one ETF from each category that investors should keep a close eye on and its holdings (read: 5 Ways to Play Rising Rates with Hedged & Inverse ETFs):

PowerShares Senior Loan ETF ((BKLN - Free Report) )

The senior loans are floating rate instruments and thus pay a spread over the benchmark rate like LIBOR, which help in eliminating interest rate risk. This is because when interest rate rises, coupons on senior loans increase while the value of the bonds decline, keeping the investments stable. Since these loans are issued by companies with below investment grade credit ratings, it usually pays has yields in order to compensate for this risk.

Given this, senior loans and the related ETFs offer higher yields along with protection against any interest rate rise, making them ideal investments for many. Further, they carry lower credit risk compared with most other assets with a similar level of yield and have low correlations with other asset classes. The most popular and liquid fund in this space is BKLN with AUM of $5.7 billion and average daily volume of over 2.8 million shares.

The fund tracks the S&P/LSTA U.S. Leveraged Loan 100 Index and holds 119 securities in its basket. It has years to maturity of 4.78 and average days to reset of just over 34. Though senior loans account for a hefty 83.4% of the assets, high yield securities also make up for 8% share in the basket. The product is slightly expensive with an expense ratio of 65 bps a year, but it pays out an attractive dividend which yields 4.01%. The ETF has added nearly 1% in the year-to-date timeframe (read: 3 ETFs Yielding Over 6% to Watch as Market Speculates Rising Rates).

iShares Floating Rate Note ETF ((FLOT - Free Report) )

Floating rate notes are investment grade bonds that do not pay a fixed rate to investors but have variable coupon rates that are often tied to an underlying index (such as LIBOR) plus a variable spread depending on the credit risk of the issuers. Since the coupons of these bonds are adjusted periodically, they are less sensitive to an increase in rates compared to traditional bonds. As such, unlike fixed coupon bonds, these will not lose value when the rates go up. Hence, it protects investors from capital erosion in a rising rate environment.

The most popular fund in this space is FLOT, which follows the Barclays US Floating Rate Note < 5 Years Index. Holding 427 securities, the fund has an average life of 1.96 years and effective duration of 0.16 years. In terms of credit quality, the ETF can be considered a relatively safe option for investors as the fund focuses on better quality notes with 91% of them rated A or higher.

The product has amassed over $3.3 billion in its asset base while trades in volume of 721,000 shares per day on average. Expense ratio came in at 0.20%. The fund is almost flat so far this year and has a dividend yield of 0.48%.

WisdomTree Barclays U.S. Aggregate Bond Zero Duration Fund ((AGZD - Free Report) )

While short-term bonds are good plays in a rising rate scenario, some niche strategy bond funds like AGZD are considered more exciting and safer picks than their short duration counterparts (see: all the Total Bond Market ETFs here).

This ETF tracks the Barclays Rate Hedged U.S. Aggregate Bond Index, Zero Duration, which provides long exposure in the investment-grade Treasuries included in the Barclays U.S. Aggregate Bond Index and short exposure in U.S. Treasuries that seek to correspond to a duration exposure matching the duration of the long portfolio, with a targeted total duration exposure of approximately zero years.  

This approach results in average year to maturity of 19.14 and effective duration of 0.20 years.  The fund is often overlooked by investors as depicted by its AUM of just $63.9 million and average trading volume of under 9,000 shares per day. Expense ratio came in at 0.23%. AGZD has delivered flat returns so far in the year but has a good dividend yield of 1.46% per annum.

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