The 10 year Treasury rate, which peaked at just over 15% in late 1981, now sits at under 2%, helping to fuel returns far above what would be expected long term from investment grade fixed income securities.
The Fed, however, has indicated that it’s preparing to reverse course on interest rates. The FOMC raised interest for the first time in nearly a decade last December and may be prepared to do so again before the end of the year. While the process for raising rates will likely be slow and deliberate moving forward, the inevitable truth remains that interest rates can’t stay as low as they are forever. When interest rates start rising, bond prices start falling.
Fixed income investors may be in a particularly precarious spot right now. A low and flat yield curve hasn’t offered much in the way of monthly income for those who may need it from their portfolios to pay the bills, so many may be reaching for the long end of the curve to boost their yields. That type of move hasn’t proven costly yet but the long end of the yield curve will, in theory, get hit the hardest as rates move up. Investors overweight in long-term bonds would be wise to consider alternative income strategies now before rates move up significantly.
It may be time for investors to consider adding floating rate bonds to their portfolios.
The $3 billion iShares Floating Rate Bond ETF (NYSE:FLOT) is one of the largest funds in its space and could be an ideal option for those looking to minimize interest rate risk in their portfolios. As the name suggests, this fund invests in fixed income securities whose interest payments adjust to reflect changes in the broader interest rate environment. The result is a portfolio whose overall duration is near zero and, therefore, protected from much of the downside risk that exists in a rising rate scenario.
That protection, however, comes at a cost. As you might expect, the rates on floating rate bonds are very low. The Floating Rate Bond ETF has a 30-day yield of 0.90% and has returned an average of just under 1% per year since its inception in 2011. The low returns the fund has seen aren’t surprising given the low rate environment the fund has operated under. Those yields will rise as interest rates begin moving up but the low risk nature of the fund may be the more appealing aspect of this product.
While income investors have had to deal with low yields for some time, they’ve also experienced little in the way of downside risk. With the Fed indicating it’s getting prepared to begin moving to a more normal rate environment, investors should begin focusing on principal preservation on their fixed income portfolios more than they have in the past. Floating rate bond funds could be a vehicle to help achieve that.
David Dierking is a freelance writer focusing primarily on ETFs, mutual funds, dividend income strategies and retirement planning. He has spent more than 20 years in the financial services industry and his background includes experience in investment management, portfolio analytics and asset/liability management at both BMO Financial Group and Strong Capital Management.
He has written for Seeking Alpha, Motley Fool, ETF Trends and Investopedia and was also included in the panel for ETFReference.com’s “101 ETF Investing Tips from the Experts”. He has a B.A. in Finance from Michigan State University and lives in Wisconsin with his wife and two daughters.