Why Floating Rate ETFs Are Bleeding Assets

Expectations of higher rates ahead should bode well for floating-rate bond ETFs, but instead, assets are flocking out of these funds.

Many investors are again growing nervous that the Federal Reserve will begin to raise rates by the end of this year. Rising 10-year Treasury yields this year say it all: They’ve rallied upward of 13 percent to 2.36 percent, and 30-year mortgage rates have pierced the 4 percent barrier.

And yet investors have been yanking assets from floating rate bond ETFs—the very securities that are supposed to protect fixed-income investors from the dangers a rising-rate environment can pose. We are talking about funds such as the iShares Floating Rate Bond ETF (FLOT | 77), the SPDR Barclays Investment Grade Floating Rate ETF (FLRN | 77) and the PowerShares Senior Loan ETF (BKLN | C).

After all, floating-rate bonds have coupons that reset regularly, essentially providing a mechanism that offsets the ravages that rising rates wreak on bond prices.

So we asked three experts to take a crack at explaining the reasons flows are heading out of these strategies and not into them. Outflows are from ETFs that own investment-grade floating-rate debt as well as high-yield bank loans, which employ rate-resetting mechanisms similar to those on floaters.

It’s all the more surprising when you look at the chart below, which shows these funds are staying in the black while plain-vanilla bond aggregate and Treasury bond ETFs are losing money as rates rise. 

Chart courtesy of StockCharts.com

Our experts’ explanations were as illuminating as they were different, and served to illustrate that in this unprecedented post-crash era of easy money and secular stagnation, few things are as simple as they once seemed.

Wayne Schmidt, CIO; Gradient Investments: Floating-Rate Bond ETFs Caught Up on Broader Bond Sell-Off

“Floating-rate ETFs have two factors at work, and each factor can have a positive or negative influence on performance. From an interest-rate-only standpoint, owing a floating-rate note tied to some short-term reset like a three-month T-bill, Libor or a one-year T-bill is advantageous in a rising-rate environment.

“The other factor at work in the floating-rate ETFs involves credit risk and credit duration. While floaters tend to perform well in rising-rate environments, the credit duration exposure can cause these ETFs to lose value.

“While I don’t subscribe to the consensus-thinking that interest rates will be significantly higher in the future, many investors are exiting the fixed-income asset class in large numbers. Floaters are being caught up in this move as investors are concerned about exposure to credit and credit duration.”

Nannette Sabo, VP and portfolio manager of Taxable Fixed Income; Cumberland Advisors: Longer End of Curve Offering Better Value

“While we perceive floating-rate securities in the investment-grade corporate space may offer attractive value, they would not make sense (for us) until the inflection point at which we have moved to upward short-term rate environments (or slightly before that time). We are holding off on investing in these securities until more stabilized markets can offer better performance opportunities.

“The exodus from funds may be related to the sell-off in Treasuries, providing a stronger perception that the Fed will delay rate hikes, and therefore the value in holding floating-rate notes may not be as advantageous perhaps. Investors may view the longer end of the bond yield curve as offering more value.”

Lucas Turton, CIO; Windham: Risky Assets Stealing Assets from Fixed Income

“We reduced our allocation to floating-rate bonds and increased our allocation to equities earlier this year when the U.S. dollar and oil prices stabilized. From a tactical perspective, floating rate debt remains the best way to reduce risk in a global portfolio. Long-term bonds are no longer a reliable defensive asset class.

“I suspect other investors sold floating-rate bonds to increase allocations to other risky assets rather than into long-term bonds.”