One of the hottest areas of the fixed income space this year is floating rate notes (FRNs), a theme benefiting exchange traded funds such as the iShares Floating Rate Bond ETF (CBOE: FLOT).
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.
“If you are a short-term investor, however, then one way to avoid the risk associated with higher interest rates is to sell your long-term bonds or bond funds and invest in floating-rate bank loans or bank loan funds,” reports The Chicago Tribune. “When you invest in these loans, when interest rates increase your investments are immediately invested in new bank loans at the higher interest rates. Your investment will not fall in value because of the higher interest rates.”
‘FLOT’ ETF Facts
The $10.65 billion FLOT tracks the Bloomberg Barclays US Floating Rate Note < 5 Years Index and holds nearly 700 bonds. FLOT is just over seven years old and is the largest ETF dedicated to FRNs.
FLOT is not completely risk-free, but it significantly reduces interest rate risk via an effective duration of just 0.15 years.
“Conversely, when you purchase a floating-rate loan or loan fund, you avoid interest rate risk but are subject to creditor risk, because no bank can guarantee it will always be in business and able to pay interest and principal back in full,” according to the Tribune.
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Regarding credit risk, that is not a significant issue with FLOT as essentially all of the fund’s holdings are rated AAA, AA, A and BBB. With interest rates expected to continue moving higher, FLOT’s allure increases.
“It is likely, in the short run, the Fed will continue to raise interest rates. Accordingly, if you are a short-term bond investor, you may want to consider part of your bond investments in floating-rate bonds,” according to the Tribune.
For more information on the fixed-income space, visit our bond ETFs category.