In anticipation of a rising interest rate environment, fixed-income investors should consider ETFs that track floating rate notes.
Should expectations of higher interest rates gain momentum, it would not be surprising to see investors embrace floating rate exchange traded funds as additions to fixed income portfolios.
The iShares Floating Rate Bond ETF (NYSEArca: FLOT) is one of the largest ETFs dedicated to floating rate notes. Floating rate notes, like the name suggests, have a floating interest rate.
Specifically, the notes’ have a so-called reset period with interest rates tied to a benchmark, such as the Fed funds, LIBOR, prime rate or U.S. Treasury bill rate. Due to their short reset periods, these floating rate funds have relatively low rate risk.
With more expecting the Federal Reserve to begin another round of interest rate hikes as soon as December, fixed-income investors are shifting into senior secured floating-rate bank loans and related exchange traded funds to hedge against rising rate risks. That includes the popular PowerShares Senior Loan Portfolio (NYSEArca: BKLN), the largest senior loan-related ETF on the market.
A senior loan is a private loan taken from an underwriting bank or a syndicate of lenders. The loans are secured in that they are backed by the borrowers’ assets, which act as collateral. If the borrower defaults, lenders have a senior claim on the defaulters’ assets. Moreover, senior secured floating-rate loans have, as their name suggests, a floating interest rate component, which fluctuates with market rates.
SEE MORE: Inside Floating Rate ETFs
“Most floating-rate bonds and loans are issued by junk-rated companies. As such they must be considered aggressive or speculative investments. If short-term benchmark rates rise without a commensurate increase in corporate earnings, the result could be increased defaults and not simply higher income streams for investors,” according to a Wealth Strategies & Management note posted by Amey Stone of Barron’s.
Since rates are typically reset once per quarter, senior loans typically have low durations – a measure of a bond fund’s sensitivity to changes in interest rates. The floating-rate component also offer investors an alternative method of earning yields while mitigating interest-rate risk. Consequently, bank loans are seen as an attractive substitute to traditional corporate debt in a rising rate environment.
PowerShares Senior Loan Portfolio (NYSEArca: BKLN)
The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.