Why Floating Rate ETFs Make Sense For Your Portfolio Right Now

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May 7, 2013 12:28pm NYSE:FLOT NYSE:FLRN

interest-ratesWith bond yields near record lows, and the losses are likely to be very high if the yields go up, most of the fixed income products offer poor returns and higher risk. This has resulted in some investors looking to more volatile stocks for bigger chunks

of their portfolios.

In this backdrop of growing fears related to interest rate hikes, investors continue to look for ways to hedge against potentially rising interest rates. One such space that has seen a great deal of interest is the floating rate securities market, which provides safe income to investors with lower downside risk.

What are Floating Rate Notes?

Floating rate notes (also known as floaters) are investment grade bonds that do not pay fixed rate to investors but instead have variable coupon rates that are often tied to an underlying index (such as LIBOR) plus a variable spread depending on the credit risk of the issuers.

As such, these securities have far lower interest rate sensitivity than their fixed rate counterparts, making them ideal choices in rising interest environments.

While these bonds usually go a long way in reducing interest rate risk, they still are subject to the credit risk of the issuer. Therefore, if the issuers go belly up, bond holders face the risk of losing their invested capital.

The coupons associated with these bonds are generally lower that most traditional fixed income securities. Moreover, while these bonds prevent losses, the flip side also holds true—these even restrict the upside (read: Junk Bond ETF Investing: Is It Too Late?).

However, given the current economic conditions and rock-bottom interest rates, investors could be better off playing the floating rate bond portfolio with minimal duration risk than the more traditional bond segment.

Floating Rate ETFs in Focus

While in the near term, floating rate bonds might underperform similar fixed securities, they could nicely complement the fixed rate-heavy portfolios of investors with more than a few years until retirement. For these investors, any of the following three ETFs could make for an excellent choice:

iShares Floating Rate Note Fund (NYSEARCA:FLOT)

Launched in June 2011, FLOT seeks to match the price and yield of the Barclays US Floating Rate Note less than 5 Years Index, before fees and expenses. The index comprises floating rate notes issued by various institutions.

The notes in the index are investment grade and have a residual maturity ranging from a month to five years. The variable coupon for the notes in the index is equal to an aggregate of 1/3/6 months LIBOR rate (i.e. reference rate) plus a variable spread depending on the credit risk of the issuers.

The fund has a lower default risk with a weighted average maturity of 1.66 years and presently holds 277 notes issued by various institutions. It pays out a dividend yield of 0.65% per annum and has added 0.12% year-to-date (read: 3 High Yield ETFs for Your IRA).

As far as credit risk is concerned, the ETF can be considered a relatively safe option for investors as the fund gets an overall credit rating of A+ by the S&P. This implies that the ETF has a strong capacity to meet financial commitments, but is somewhat susceptible to adverse economic conditions and changes in circumstances.

Also, an effective duration of 0.14 years signifies negligible vulnerability to interest rate risk thanks to the resetting of LIBOR. The ETF charges a paltry 20 bps in fees per year from investors and is the most popular fund in the space. It has witnessed an impressive inflow of over $1.1 billion so far this year, pushing its asset base to $1.5 billion.

SPDR Barclays Capital Investment Grade Floating Rate ETF (NYSEARCA:FLRN)

This ETF seeks to replicate the performance of Barclays Capital U.S. Dollar Floating Rate Note less than 5 Years Index. The Index measures the performance of floating rate notes which are U.S. dollar denominated and uses the 3-month LIBOR as the reference rate.

The ETF debuted in December of 2011 and since then has managed to attract a moderate asset base of $24.4 million. The weighted average maturity and an effective duration of the ETF are 1.60 years and 0.13 years, respectively.

FLRN holds 142 securities and charges just 15 basis points in fees and expenses. The ETF lacks popularity as indicated by an average daily volume of 10,000 shares.

The product has an average yield of 1.04%, making it one of the best in the space in terms of yields. It has gained 0.49% so far this year, and has been a low volatility choice.

Market Vectors Investment Grade Floating Rate ETF (NYSEARCA:FLTR)

This fund tracks the Market Vectors Investment Grade Floating Rate Bond Index which measures the performance of investment rate floating rate bonds that are issued by U.S. firms as well as global corporates.

Launched in April of 2011, the product has amassed $15 million in AUM while charging investors 19 bps in annual fees. However, it has a wide bid/ask spread as it trades in paltry volumes of roughly 18,000 shares per day, thereby increasing the total cost for the product.

With holdings of 51 securities, FLTR has comparatively high-weighted average maturity of 2.29 years and average modified duration of 2.24 years. Therefore, it is more sensitive to interest rate movements than most of its counterparts.

The ETF is currently sporting a yield of 0.77% and has added 1.09% in the year-to-date time frame.

This article is brought to you courtesy of Eric Dutram From Zacks.

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