Floating Rate Notes Aren’t Perfect

In 2022, carnage is abound in the fixed income market. So bad are things in the bond market, that some of the strategies that should be working in this environment are only “working” to the extent that they are performing less poorly than peers and aggregate bond funds.

Take the cases of floating rate notes (FRNs) and Treasury Inflation Protected Securities (TIPS). The Bloomberg Barclays U.S. Treasury Inflation Protected Securities (TIPS) Index is off a staggering 9.3% year-to-date despite inflation remaining high.

The Bloomberg Barclays US Floating Rate Note < 5 Years Index is lower by just half a percent and in both cases, those benchmarks are beating the Bloomberg US Aggregate Bond Index, which is lower by 10%, as of May 10.

All of that is to state the obvious: Things are treacherous in the bond market this year, but there are some credible alternatives out there to FRNs and TIPS, particularly for risk-tolerant investors.

Rate-Hedged ETFs Have Some Appeal

First, a disclaimer. Rate-hedged bonds ETFs, including the ProShares High Yield—Interest Rate Hedged ETF (HYHG) and the ProShares Investment Grade-Interest Rate Hedged (CBOE:IGHG) aren’t perfect and that much is confirmed by their year-to-date performances.

That said, products like these could be interesting considerations in this climate because they offer bigger yields than FRNs and TIPS and erosion in the corporate bond market this year seems to imply default levels that aren’t likely to come to pass. Additionally, rate-hedged strategies offer arguably under-appreciated benefits relative to FRNs.

“From an investor perspective, a debt instrument that pays out increasingly higher coupons as rates rise sounds almost idyllic,” writes Daniel Bush, ProShares senior investment strategy analyst. “However, floating rate debt can burden companies—especially lower-rated companies—with greater than expected debt service payments. Those higher debt payments could mean greater credit risk for investors.”

History confirms that corporate bonds often top Treasuries as rates rise because contracting credit spreads augment some of the risk incurred by way of soaring government bond yields. Underscoring the utility of IGHG in particular, is the fact that many traditional investment-grade corporate bond funds carry longer duration, meaning they too are vulnerable to rising rates.

An advantage of HYHG relative to bank loan funds – another popular rising rates strategy -- is that the ProShares ETF doesn't feature callable bonds – an important point for advisors to consider because callable bonds can have limited upside potential.

All About Keeping Duration

It’s not a revelation that keeping duration short this year is the best way to limit fixed income. Fortunately, that’s the primary aim of rate-hedged strategies.

“Short-duration strategies could be the right play, with minutes from the Fed’s March meeting indicating that the FOMC is likely to start shrinking its balance sheet quickly. This could put additional upward pressure on rates,” concludes Bush.

Something else to consider: If the April reading of the Consumer Price Index is higher than expected, that could compel the Fed to become more aggressive with its pace of rate hikes, potentially boosting the allure of rate-hedged ETFs.

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