Floating-Rate Bond ETFs Take Center Stage

December 17, 2013

These funds have attracted investors looking to combat rising interest rates, and that popularity should accelerate in 2014.

Floating-rate bond ETFs have been very popular this year, partly because of the yields they deliver, but also for the interest-rate risk protection they provide. Come 2014, these ETFs should only become more popular as investors brace for the Federal Reserve to begin pushing interest rates higher.

In addition, the U.S. Treasury has announced it will start offering its own floating rate bonds in January, the first new Treasury product in nearly two decades. At least three ETF issuers have already detailed plans to launch ETFs focused on these new Treasury securities with products that will certainly attract more investors to the segment.

The iShares Floating Rate Bond ETF (FLOT | A-96), for example, has raked in more than $3.15 billion in net new assets in 2013, growing to become a $3.5 billion fund.

FLOT, which tracks a market-weighted index of U.S.-dollar-denominated, investment-grade floating rate notes with maturities of zero to five years, is one of only nine floating-rate bond ETFs that have done well in asset-gathering this year. The segment attracted more than $9 billion in net assets in 2013, according to IndexUniverse data.

The most popular ETF in this group is the first-to-market, high-yielding PowerShares Senior Loan ETF (BKLN | B), which attracted more than $4.85 billion in net new assets this year, helping to make it a $5.8 billion ETF. BKLN tracks a market-value-weighted index of senior loans, including leveraged, bank and floating-rate loans.

What’s appealing about floating-rate securities, which typically have two- to five-year maturities, is that they have variable coupon rates that reset regularly. The rate is set as a spread plus a reference benchmark rate such as Treasury rates or Libor, and that reset-rate feature protects the notes from interest-rate risk.

Floaters are generally designed to offer protection against price volatility caused by changes in interest rates. Unlike fixed-rate debt securities, prices on floating-rate securities are less sensitive to fluctuations in the interest rates because the coupons of the bond adjust regularly, partially offsetting the impact of changes in interest rates. It’s unsurprising, then, to see floating-rate debt become so popular in a rising-rate environment.

But that’s not to say that funds like FLOT or BKLN don't bring to the table risks of their own. At the end of the day, higher interest rates can increase the credit risk associated with floaters, as bond issuers find it harder and harder to meet their debt obligations, IU ETF analyst Howard Lee pointed out. Indeed, investors opting for floating-rate debt are taking on credit risk.

The flip side of that credit risk is the further out in the credit yield curve, the wider the spread over Treasury yields, meaning rising rates asymmetrically impact a floater in terms of income potential, Lee said.

In the case of FLOT, it’s a short-term fund, and like its Treasury ETF counterparts of similar portfolio maturity, it’s not serving up much in the way of yield. In fact, FLOT’s yield to maturity is a modest 0.53 percent, and its 30-day SEC yield is currently 0.33 percent—the latter a metric that reflects interest earned in the period after fund expenses.

FLOT_BKLN_SHY_YTD_Performance

Chart courtesy of StockCharts.com

 

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