Floating rate notes (FRNs) and the related floating rate ETFs are receiving renewed attention this year as fixed income investors seek alternatives to traditional government bonds at a time when the Federal Reserve is increasing borrowing costs.

One of the fastest-growing exchange traded funds this year in the FRN category is the WisdomTree Bloomberg Floating Rate Treasury Fund (NYSEArca: USFR). USFR, which debuted in February 2014, follows the Bloomberg U.S. Treasury Floating Rate Bond Index. The fund’s holdings are priced at a spread over 3-month Treasury bills. Floating rate notes featured in USFR mature in 2019 and 2020.

“A key attribute that sets these notes apart is that instead of paying a fixed rate of interest like other Treasuries, FRN coupon payments are based on a reference rate (90-day t-bills) plus a spread,” said WisdomTree in a recent note. “Since 90-day bills are auctioned every week, effective duration of FRNs is one week, which allows investors to capture higher rates of income as short-term rates rise. Given that these securities are assumed to be free of default risk, their value is linked to the rate of interest at each weekly auction. Since 90-day t-bills are among the most sensitive to interest rate changes conducted by the FOMC, this provides an opportunity to boost income as the Fed hikes rates.”

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.

Important Treasury Considerations

Looking ahead, the floating rate notes will generate more interest if Treasury prices fall and yields rise further, which should play out if the Fed continues on its interest rate normalization schedule.

USFR has a 30-day SEC yield of 1.89%, which is better than what is found on many short-term cash investments. All of the fund’s holdings are rated AAA, so credit risk is not an issue. Floaters are designed to be low duration products as highlighted by USFR’s effective duration of just 0.02 years.

“USFR has had annualized returns of 1.43% over the last 1 year, 1.14% over the last 2 years, 0.85% over the last 3 years, and 0.55% since the fund incepted on February 4th, 2014 — a testament to the FRN’s ability to efficiently participate in rising interest rates. Additionally, when looking at USFR versus the Prime Category, a group that will typically take on additional credit risk to achieve higher yields, USFR has still outperformed since its inception,” according to WisdomTree.

For more on the bond market, visit our Fixed Income Channel.

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.

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