The thirty years long bond bull finally appears to be nearing its end, as the Fed has finally hit the taper chord. This comes on the back of a gradually improving economy and declining unemployment levels. The tapering immediately raises the likelihood of increase in rates.
However, the Fed has assured that it will be following an accommodative monetary policy, till the unemployment rate drops below 6.5% or maybe even after it reaches that level. Hence, the Fed is expected to keep the short term interest rates lvery ow for the major part of 2014.
At the same time, with things gradually becoming brighter on the economic front, the long term rates may continue to inch up.
Recently improved labor and housing markets, business spending and household consumption have led major benchmark indices Dow and S&P to clock another record high.
And, the rates for the 10-year U.S. Treasury have climbed above the 3% mark on the back of the strengthening economy.
What should you invest in given the situation?
Floating rate notes, via ETFs, are definitely an option for investors concerned about rising interest rates. These instrument are a defensive bet against rising rates.
Floating rate bonds (also known as floaters) are bonds that pay variable coupon rates indexed to a benchmark interest rate (usually the LIBOR and Treasury rates) plus a premium depending on the credit rating of the issuer. (read: WisdomTree Files for Floating Rate Treasury ETF)
Since the coupons of these bonds are adjusted periodically, they are less sensitive to increase in rates, compared to plain vanilla traditional bonds.
As such, unlike fixed coupon bonds – they will not lose value as rates tread northwards. Hence, it protects investors from capital erosion in a rising rate environment.
Floating Rate ETFs in Focus
Among the nervousness of rising rates this year, the floating rate bond space proved to be extremely popular among investors attracting a huge inflow so far. The below mentioned ETFs could be an excellent choice for investors wanting to play in the floating rate bond space.
iShares Floating Rate Note Fund (NYSEARCA:FLOT)
Launched in June 2011, FLOT tracks the performance of Barclays U.S. Floating Rate Note less than 5 Years Index. The index comprises U.S. dollar denominated investment grade floating rate notes with a remaining maturity of greater than one month and less than five years.
The variable coupon for the notes in the index is equal to an aggregate of 1/3/6 months LIBOR rate plus a fixed coupon spread depending on the credit risk of the issuers.
The fund currently holds 348 notes with a weighted average maturity of 1.7 years. The ETF charges a low 20 bps in annual fees from investors. Also, an effective duration of just 0.13 years signifies negligible vulnerability to interest rate risk.
Moreover, the product has just 9.28% of its total assets in the top ten holdings, signifying its diverse spread. This diversification limits the default risk of any single issuer.
It pays out a dividend yield of 0.47% per annum and has added 0.63% year to date. The product’s huge popularity this year has pushed its assets base to $3.5 billion.