When interest rates are rising, as is the case today, there are some corners of the fixed income market money managers frequently gravitate to.
Floating rate notes (FRNs) are atop that list. The premise is simple. FRNs, or “floaters”, have variable interest rates, making the asset class attractive as Treasury yields climb. FRNs also have shorter maturities, making them less vulnerable to rising rates.
“The interest rate for an FRN is tied to a benchmark rate. Benchmarks include the U.S. Treasury note rate, the Federal Reserve funds rate—known as the Fed funds rate—the London Interbank Offered Rate (LIBOR), or the prime rate,” according to Investopedia. “Floating rate notes or floaters can be issued by financial institutions, governments, and corporations in maturities of two-to-five years.”
Sounds pretty good and it is. The Bloomberg Barclays US Floating Rate Note < 5 Years Index is flat year-to-date while the Bloomberg Barclays US Aggregate Bond Index is down 2.72%.
Hedging Bets Pays Off
Believe it or not, bond funds, particularly the exchange traded funds variety, are ripe for disruption and some of that disruption occurred in products designed to guard against rising rates. That's a positive for advisors and clients because FRNs, while useful, aren't perfect.
“The caveat here is that floating rate bond ETFs involve limited credit exposure because floating rate bonds are often short in maturity,” according to ProShares. “Longer-dated bonds include not only additional interest rate risk, but also additional credit premium. Since credit exposure and interest rate risk are two of the key drivers for bond returns, switching to a floating rate strategy can limit an investor’s potential returns.”
Alright, I'll oblige the skeptics and acknowledge that ProShares has skin in this game. The firm issues a pair of interest rate-hedged ETFs – alternatives to FRN funds. Put the skepticism to bed because rate-hedged ETFs are credible alternatives to FRNs.
“Interest rate hedged bond ETFs, on the other hand, are designed to target a duration of zero while maintaining full credit exposure and return potential,” adds ProShares. “Because credit spreads typically tighten as rates rise, interest rate hedged bond ETFs may produce higher returns in a rising rate environment. It is, however, important to consider that this potential excess return includes additional risks, with the strategy potentially underperforming if credit spreads widen.”
The ProShares Investment Grade-Interest Rate Hedged (CBOE:IGHG) is up 1% year-to-date. That's not setting the world ablaze, but that's better than what aggregate bond and FRN funds are offering. Plus, IGHG yields 2.67% – 33 basis points more than the Markit iBoxx USD Liquid Investment Grade Index.
During episodes of rising rates from the end of 2013 through the end of last year, the FTSE Corporate Investment Grade Index – IGHG's underlying index – returned 8.47%. That's more than quadruple the returns offered by the aforementioned floating-rate benchmark.
“Floating rate bond ETFs can help investors reduce their interest rate risk, but they have some potential drawbacks. If you are looking to maintain return potential and to take advantage of tightening credit spreads, consider an interest rate hedged bond ETF such as IGHG,” notes ProShares.
It doesn't have to be with IGHG, but the current environment is conducive to advisors examining rate-hedged strategies in the name of improving clients' fixed income outcomes and income streams.
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