FLOATING RATE NOTES
Why: As part of a portfolio’s fixed income allocation, floating rate notes can be used to shorten overall portfolio duration and prepare for a rising rate environment. As the Fed looks to taper its monthly bond purchases, an allocation to these notes can shorten overall portfolio duration, decreasing sensitivity to the negative effects of rising long-term rates. In addition, as the Fed ultimately begins to raise the short-term Fed Funds rate—which it has projected it will do in 2015—investors in floating rate notes may potentially see increased income from the fund’s underlying bonds due to increases in 3-month LIBOR rates.
How: Floating rate notes are variable rate bonds with minimal duration. Their coupon rates reset on a regular basis, based on a specific index, such as 3-month LIBOR. Floating rate notes provide exposure to these bonds issued to US corporations and floating rate, dollar-denominated issues of non-US corporations, governments and supranational entities.
CROSSOVER BONDS
Why: While lower rated issues generate outsized returns over certain periods, they do so with significantly greater volatility than higher rated bonds—the main reason being that lower rated bonds tend to default with much greater frequency than higher rated bonds. Crossover bonds have less credit risk than many high yield bonds, yet generally offer higher yields than most investment grade bonds.
In addition, because higher yielding corporate bonds tend to have shorter maturities, crossovers may have less sensitivity to interest rate changes (i.e., lower duration) than higher rated bonds.
How: The BofA Merrill Lynch US Diversified Crossover Corporate Index is comprised of an approximately 50%/50% split between BBB-and BB-rated bonds. This targets the portion of the US corporate bond market that has historically offered the best risk-adjusted returns as measured by Sharpe ratios.
ULTRA SHORT-TERM BONDS
Why: Ultra short-term bond funds typically invest in a portfolio of fixed income securities targeting a fund duration of one year or less. Additionally, most ultra short-term bond funds invest in high quality securities such as treasuries, and highly rated corporate and asset-backed bonds. Because of the short duration and high quality nature of the portfolios, there is less likelihood of price fluctuations than funds focused on longer duration and/or lower-rated fixed income securities.
How: Allocating to an ultra short-term bond fund, such as ULST, can shorten overall portfolio duration, decreasing sensitivity to the negative effects of rising long-term rates. Acting as a portfolio diversifier, ultra short term bonds also have low correlations to other asset classes, seek to provide downside protection and can be a source of immediate to intermediate liquidity.
ETF Trends note: This information is part of the whitepaper “A Blank Slate: Fixed Income for the Next Cycle” by State Street Global Advisors.