Fund manager David Fabian examines the big recent inflows into floating rate and variable rate funds, and what the trend may mean for investors.
The first six months of 2016 were characterized by a sharp drop in U.S. interest rates as investors flocked to the safety of Treasury, municipal, and investment grade corporate bonds. This created significant inflows to diversified exchange-traded funds that track these asset classes in an attempt to ride the building wave of momentum. However, as the ship became overloaded to one side, it was only a matter of time before it began to swing back towards a relative state of equilibrium.
One major indicator of this trend, the 10-Year Treasury Note Yield ($TNX), fell to an all-time low of 1.34% near the mid-point of the year. This index has now reversed course and risen to a four-month high near 1.75%.
The reversal in interest rates, while still short-term in nature, puts a damper on the momentum that many traditional bond funds had demonstrated. To counteract this volatility and potentially earn a respectable yield in the process, some income investors are returning to “variable rate” and “floating rate” ETFs.
According to data from ETF.com, the following list of prominent funds in this class have garnered positive net inflows over the last four months.
Floating rate notes and senior loans became well-known during the 2013 taper tantrum as a defensive tool to combat a rising interest rate environment. The most prominent feature of these debt instruments is the stipulation that the coupon rate will float in relationship to a benchmark such as 3-month LIBOR. If interest rates rise, the coupon rate also has the ability to move higher, which increases the market value of the security.
One of the largest funds in this category is the PowerShares Senior Loan Portfolio (BKLN). This ETF tracks an index of the 100 largest floating rate bank loans and has a distribution rate of 4.28%. The $1.6 billion in new inflows over the last four months has swelled the total assets in BKLN to $6.16 billion.
The steady credit environment, combined with the uptick in interest rates, has been a tailwind for this fund in 2016. BKLN recently hit new all-time, dividend-adjusted highs even as traditional bond funds have drifted lower in price.
Senior loans, while attractive as rates rise, do also face significant risks as well. These securities tend to be less liquid than other heavily traded areas of the bond market. They also straddle the line between investment grade and lower credit tiers. This makes them highly correlated to the overarching credit environment, similar to junk bonds.
If credit quality is a major concern, the iShares Floating Rate Bond ETF (FLOT) is an alternative to study. This ETF has garnered the second largest share of assets in the floating rate category since early July, with $309 million in net new inflows. FLOT invests in a broad basket of over 440 floating rate securities that are primarily rated as investment grade or better. The higher credit quality comes with a commensurate lower effective yield of just 1.00%.
Finally, it’s worth noting that the PowerShares Variable Rate Preferred Portfolio (VRP) has been attracting meaningful assets as well. This ETF takes a different approach to owning preferred stocks by selecting preferred securities with a floating dividend option. The index is primarily made up of financial companies and sports a yield of 4.90%.
The Bottom Line
Fund flows are always an interesting study in investor behavior that are generally driven by short-term performance chasing or risk aversion. While the floating rate category may provide some relief from the rising rates under specific circumstances, they don’t represent the same attributes that fixed-coupon bonds provide for core exposure. These investment vehicles may be more suitable to provide tactical exposure to a specific trend or as a dynamic component to an ETF income portfolio.
Disclosure: At the time this article was written, some clients of FMD Capital Management owned shares of FTSL.
This article is brought to you courtesy of FMD Capital.