Floating-Rate Notes Have Risks, Rewards | ETF Trends

Not much is working in the bond market this year, and with the Federal Reserve planning more, potentially larger rate hikes in a bid to quash inflation, things could get worse before they get better.

In other words, less bad is carrying the day in many corners of the bond market, including floating-rate notes. Take the case of the VanEck Vectors Investment Grade Floating Rate ETF (FLTR). FLTR follows the MVIS US Investment Grade Floating Rate Index and is down 2.26% year-to-date. That’s vastly superior to the nearly 11% shed by the widely observed Bloomberg US Aggregate Bond Index.

FLTR and other FRN exchange traded funds typically invest in bank loans that come with adjustable rates — a strategy that’s beneficial when interest rates rise. In fact, FLTR is outperforming other funds in the bank loan category.

“That mechanism cushions these funds from the price declines seen on bonds with fixed interest rates. The result: This year, the average bank loan fund is down 5.8%, while the average core bond fund has dropped 10.8%,” noted Morningstar analyst Katherine Lynch.

Still, FRNs are examples of trade-offs that come with bond investing. In order to gain the higher yields and interest rate protection offered by this asset class, investors often have to deal with the junk ratings that in many cases accompany bank loans.

“The loans that floating-rate funds purchase are below investment grade, making them risky if the U.S. enters a recession and corporations begin to default. Investors should think of them as they would high-yield bond funds. Among bond funds, floating-rate funds are definitely at the complicated end of the spectrum,” added Lynch.

That makes the $1.1 billion FLTR all the more relevant because all of its 226 holdings carry investment-grade ratings. In fact, roughly 69% of the ETF’s holdings are rated AA or A, according to issuer data. With a 30-day SEC yield of 2.3%, FLTR provides the income benefits and rate protection investors look for with FRNs while keeping credit risk relatively low.

“The outlook for floating-rate funds hinges on the outlook for the broader economy. If economic conditions worsen, that would mean an increase in bank loan defaults, hurting performance for these funds. Defaults for bank loans remain below their historical averages right now,” concluded Lynch.

FLTR could offset some of those risks with its investment-grade lineup and exposure to floating-rate notes issued in countries beyond the U.S.

For more news, information, and strategy, visit the Beyond Basic Beta 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.