FLTR: Question & Answer
February 01, 2022
Read Time 16 MIN
- Q: What are floating rate notes and how big is the market?
- Q: How does an FRN coupon adjust?
- Q: What impacts the price of FRNs?
- Q: How do FRNs differ from loans or other short duration strategies?
- Q: Why are FRNs attractive now?
- Q: How can investors use FRNs within a portfolio
- Q: What makes FLTR’s strategy unique?
- Q: Isn’t LIBOR going away? How will that impact FRNs and FLTR?
- Q: What is SOFR and how does it differ from LIBOR?
- Q: How to buy VanEck ETFs?
Q: What are floating rate notes and how big is the market?
A: Unlike other bonds which typically pay a fixed coupon, floating rate notes (or “FRNs”) pay a coupon that adjusts periodically with prevailing interest rates. Because FRN coupons reflect current interest rates, the price of the bonds are not sensitive to changes in rates. This is in contrast to fixed rate bonds in which the coupon does not change with interest rates but the price will increase/decrease as rates decline/increase. As a result, FRN prices have near-zero sensitivity to interest rates and coupons will actually increase as rates go up, making them potentially attractive in rising rate environments. In other respects such as credit risk, they are similar to other bonds from the same issuer.
The FRN market was approximately $290 billion in size as of 12/31/2021.1 The size of the market tends to correlate with the level of short-term interest rates, as demand for FRNs tends to increase as rates rise and vice versa. Both the 3-month U.S. dollar London Interbank Offered Rate (LIBOR) and target Fed Funds rate declined significantly since the beginning of 2019, and accordingly the market size has declined over the past three years, after increasing steadily in the years prior to 2019.
LIBOR vs Fed Funds
Source: Factset and FRED Economic Data as of 12/31/2021. Past performance is not indicative of future results.
FRNs are often issued as a component of multi-tranche issuances along with fixed rate bonds. Banks and other financial companies tend to be the largest issuers of floating rate notes, as they help to match the duration of their assets. Non-corporate issuers, including the U.S. Treasury and government agencies, are also very active in the market. The overall FRN market is predominantly rated investment grade, and is concentrated in bonds with maturities of less than five years.
Q: How does an FRN coupon adjust?
A: The terms of an FRN issue specify a coupon formula, which is generally a fixed spread above a floating rate. In the majority of cases, the floating rate is defined as 3-month LIBOR, although issuers are increasingly referencing other floating rates (as discussed further below). The spread over the floating rate primarily compensates investors for the additional credit risk (e.g., the risk of a deterioration in credit quality including a potential default) they are assuming by investing in the bond. Credit spreads generally increase as the creditworthiness of an issuer decreases. In addition, credit spreads for longer maturities are typically higher than lower maturities.
Spreads Increase With Maturity
Source: FactSet as of 12/31/2021, based on the constituents of the MVIS US Investment Grade Floating Rate Index. Past performance is not indicative of future results.
For example, an FRN may specify a quarterly coupon of 3-month LIBOR plus a spread of 1%. If the coupon period is from January 1 to March 31, the floating rate would typically be set at the beginning of the period (or more typically, a few days prior to the start). In this example, assume the coupon is based on the rate two business days prior to the start of the period, or December 30. On December 30, 2021, 3-month LIBOR was at 0.21%, so the annualized coupon for the three month period would be 1.21%. Three months later, if LIBOR increases to 0.50%, the next coupon would accrue at an annualized rate of 1.50%.
Q: What impacts the price of FRNs?
A: As mentioned, FRN coupons adjust with prevailing short-term interest rates. As a result, prices have virtually no sensitivity to changes in interest rates. Investors will not suffer mark-to-market losses as interest rates rise, but will also not benefit from interest rate declines. This is in contrast to fixed coupon bonds, which will exhibit a sensitivity to interest rates that is measured by interest rate duration. Longer maturity bonds have longer durations, all else equal.
Other changes in the market can impact FRN prices, however, primarily due to the fixed spread that is specified for each bond. The spread paid above the floating rate does not change over the life of the bond. Because this spread primarily reflects credit risk, changes in the creditworthiness of the issuer and general changes in credit conditions can impact FRNs. If credit spreads widen, the value of an FRN may decline to compensate investors for the additional spread that is needed. This sensitivity is referred to as spread duration. In contrast to interest rate duration, which measures price sensitivity to interest rates, spread duration measures sensitivity to a change in credit spreads of that issuer. Longer maturities and more credit oriented sectors will generally have higher spread durations than lower maturities and non-credit issuers such as government agencies. Investors are typically compensated for this additional spread risk through a higher spread, and therefore a higher coupon.
The result of this spread exposure is potentially more volatility and drawdowns when spreads widen as compared to non-credit sensitive FRNs such as those issued by the U.S. Treasury, but also a higher yield which historically has allowed FRNs to recover and outperform in the long-term. In many ways, the risk profile of corporate FRNs is closer to short-term corporate bonds, which also have credit exposure but also greater sensitivity to interest rate movements compared to corporate FRNs. This rate exposure may help or hurt performance depending on the interest rate environment. Recently, performance of fixed coupon bonds, even with shorter maturities, has suffered due to rising rates.
FRNs with Higher Spread Exposure Outperformed, With Greater Volatility
Source: Morningstar Direct and ICE Data Indices. Corporate FRN is represented by MVIS® US Investment Grade Floating Rate Index; U.S. Treasury FRN is represented by ICE BofA US Floating Rate Treasury Index. 1-3 Year Fixed Rate Corporate is represented by the ICE BofA 1-3 Year US Corporate Index. Past performance is not indicative of future results.
Q: How do FRNs differ from loans or other short duration strategies?
A: Compared to investment grade short term bonds (e.g., 1-3 year or 1-5 year fixed coupon strategies), the primary difference is that FRNs have a near-zero duration and virtually no sensitivity to changes in interest rates. Therefore, investors looking to shorten their overall exposure to interest rate increases may find an allocation to FRNs attractive. Since FRNs are also investment grade, this does not entail assuming significantly more credit risk. The yield on FRNs will vary based on prevailing rates and spread levels. There have been times historically when the yield on FRNs was in line or even higher than short term bonds, but currently fixed rate short-term bonds offer a yield advantage. However, FRNs will not lose value if rates increase while short-term bonds will suffer.
Significantly Lower Interest Rate Sensitivity
As of 12/31/2021
Source: Bloomberg Barclays, Factset and Morningstar as of 12/31/2021. Floating Rate Notes represented by the MVIS US Investment Grade Floating Rate Index. 1-5Y US Corp is represented by the Bloomberg Barclays US Corporate 1-5 Y Index. 1-5Y US Gov/Credit is represented by the Bloomberg Barclays 1-5 Year US Government/Credit Index. Index performance is not representative of Fund performance. Past performance is not indicative of future results.
Similar to FRNs, bank loans also have coupons that are based on floating rates and therefore have very little sensitivity to changes in interest rates. In that sense, both can be attractive as portfolio diversifiers, particularly if rates are rising or expected to rise. However, FRNs and bank loans have very different credit profiles. Although generally secured by an issuer’s assets, the loan universe is predominantly high yield, and therefore investors earn higher spreads to reflect the much higher level of credit risk. Loans tend to be more illiquid and often have extended settlement periods. This can be a concern in periods of high volatility and risk-off environments, where it may be more difficult to sell loans to satisfy redemptions. Loan returns have also exhibited much higher volatility compared to FRNs historically. Bank loans often feature “LIBOR floors,” which set a minimum level for the floating rate. When the floating rate is below the floor, bank loans that have such a floor effectively become fixed rate securities that will exhibit sensitivity to interest rate movements. For example, according to J.P. Morgan, 80% of loans issued in 2021 had a floor, with an average floor of 0.67%. For the year, 3-month LIBOR averaged 0.16% and did not exceed 0.24%.
Q: Why are FRNs attractive now?
A: Since the U.S. Federal Reserve started cutting its target rate in 2019, and then brought rates to zero following the onset of the COVID-19 pandemic, short-term rates have been low and concerns about rising rates have generally been muted. Although FRNs can offer diversification benefits in all environments, investors were less concerned about their duration exposure.
However, this began to change in 2021 as inflation crept upwards and hit its highest level in 30 years. With strong economic growth and higher inflation set to continue, expectations for the end of quantitative easing and rate increases have quickly been brought forward, with the market now anticipating four rate hikes in 2022 beginning as soon as March. The impact has been a recent uptick in LIBOR and other short-term rates, reflecting this potential. In addition, fixed coupon bonds have had negative returns, as longer term interest rates have also increased.
FRNs Have Outperformed YTD As Rates Moved Upwards
Source: Morningstar as of 1/20/2022. Corporate FRNs represented by MVIS® US Investment Grade Floating Rate Index; US High Yield represented by ICE BofA US High Yield Index; US AGg represented by ICE BofA US Broad Market Index; US IG Corporates represented by ICE BofA US Corporate Index; 30 Year U.S. Treasury represented by ICE BofA Current 30 Year US Treasury Index. Past performance is not indicative of future results.
In this environment of rising rates, FRNs may be an attractive solution for income investors. They can allow investors to build fixed income portfolios that are more resilient against rises in interest rates, and produce higher levels of income as rates increase. In addition, the strong credit environment, driven by continued economic strength, is positive for credit spreads and may benefit investment grade corporate FRNs.
Q: How can investors use FRNs within a portfolio
A: The unique characteristics of FRNs provide several benefits within a fixed income portfolio:
- Protection against rising rates: the near-zero duration makes FRN prices insensitive to increases in interest rates, which may be particularly attractive when rates are rising or expected to rise in the near future.
- Diversification: Because they are insensitive to movements in interest rates, FRNs have a lower correlation to other fixed rate asset classes than short-term bonds. Further, the sector mix of the FRN universe differs from that of the broader corporate bond market, so may provide sector and issuer diversification as well.
- High quality: FRNs are rated investment grade, as opposed to bank loans which are issued by high yield borrowers and generally have lower levels of liquidity.
The high quality and near-zero duration can also make FRNs attractive as a cash alternative or complement for investors with longer holding periods who can tolerate a degree of volatility that comes from movements in credit spreads.
Q: What makes FLTR’s strategy unique?
A: VanEck® Investment Grade Floating Rate ETF (FLTR®) provides access to corporate FRNs, allowing investors to efficiently gain exposure to this segment and potentially benefit from rising rates. Investors may also benefit from the diversification and high credit quality that FRNs can provide.
Further, FLTR’s index is designed to provide an enhanced yield versus the broader FRN universe. This is done in two ways. First, FLTR’s index focuses on corporate FRNs only, and does not include non-credit issuers such as the U.S. Treasury and government agencies. This results in a higher average spread and a higher overall yield versus the broad market. Second, FLTR’s index re-weights constituents so that there is a higher weight towards longer maturity bonds. As mentioned above, credit spread curves tend to be upwards sloping, and a higher weight to longer maturities results in higher spreads, without assuming additional interest rate risk.
The result of this unique design is a higher yielding strategy that has outperformed other ultrashort investment options historically.
Performance Relative to the Morningstar Open End Funds – U.S. – Ultrashort Bond Category
As of 12/31/2021
|Trailing Returns||QTD||Peer group percentile||Peer group rank||1 Year||Peer group percentile||Peer group rank||2 Years||Peer group percentile||Peer group rank||3 Years||Peer group percentile||Peer group rank||5 Years||Peer group percentile||Peer group rank||5/1/'11 - 12/31/'21||Peer group percentile||Peer group rank|
|VanEck Investment Grd FI Rt ETF||-0.18||52||129||0.59||12||29||1.05||26||60||2.47||6||12||2.18||7||13||1.52||17||15|
|US Fund Ultrashort Bond||-0.15||46||115||0.31||23||56||0.85||41||94||1.59||38||83||1.56||45||80||1.10||54||46|
|# of Funds Ranked||247||239||229||214||175||84|
Source: © Morningstar, Inc. All Rights Reserved. Data as of 12/31/2021. The information contained herein: (1) is proprietary to Morningstar; (2) may not be copied or distributed; and (3) is not warranted to be accurate, complete or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information. Past performance is no guarantee of future results. The peer group chart presents trailing total return percentile rankings against the Morningstar Open End Funds – U.S. – Ultrashort Bond category, which comprised 247 funds as of 12/31/2021.
This chart is for illustrative purposes only. Performance information for the Fund reflects temporary waivers of expenses and/or fees. Had the Fund incurred all expenses, investment returns would have been reduced. Investment return and value of the shares of the Fund will fluctuate so that an investor's shares, when sold, may be worth more or less than their original cost. Performance may be lower or higher than performance data quoted. Fund returns reflect dividends and capital gains distributions. Performance current to the most recent month end is available by calling 800.826.2333 or on vaneck.com. VanEck Investment Grade Floating Rate ETF commenced on 4/25/2011. See disclaimers at the end of this presentations. See descriptions for active mutual fund open-end peer group universe and category average (including mutual funds and ETFs) at the end of this presentation.
Q: Isn’t LIBOR going away? How will that impact FRNs and FLTR?
A: In a word, yes – LIBOR’s days are numbered. In fact, outside of U.S. dollar rates, LIBOR already ceased publication late last year. Most tenors of U.S. dollar LIBOR, including the widely referenced 3-month LIBOR rate which many U.S. FRNs reference, will continue to be published until June 30, 2023. This transition away from LIBOR has been in the making for many years. In addition to several scandals that plagued the LIBOR rate-setting process following the financial crisis, a more fundamental issue with LIBOR is that, despite the fact that approximately $350 trillion of securities and derivatives are tied to the rate, it is not viewed as a representative cost of borrowing. Originally designed to reflect the borrowing rates between large international banks, the way banks fund themselves has changed and very little borrowing actually occurs in wholesale funding markets. Accordingly, market participants and regulators have been working for years to replace LIBOR with a rate that is not prone to manipulation, and also a rate that is transaction-based to reflect actual borrowing costs.
In the U.S., the Secured Overnight Funding Rate (SOFR) has emerged as the most likely replacement among a few other possible alternatives. Issuers, underwriters and other market participants were told by regulators not to enter into new financial contracts after December 31, 2021, and in June 2021, swap dealers largely transitioned away from LIBOR-based contracts. The growth of the SOFR market and new FRN issuance has resulted in 48% of the MVIS US Investment Grade Floating Rate Index being tied to SOFR on 12/31/2021, up from only 4% on 12/31/2020.2
One of the bigger challenges that has faced the market over the past several years is how to deal with FRNs issued many years ago that mature after June 2023, in which the governing terms may not contemplate a permanent cessation of LIBOR. In the absence of a mechanism to transition to SOFR or some other alternative rate, these FRNs risk becoming effectively fixed rate bonds if they continue to reference the last published LIBOR rate. This has been addressed in two main ways. First, for FRNs issued in the past few years, recommended “fallback” language should help to provide a smooth transition. Second, a legislative solution that covers all New York state governed securities (the vast majority of FRNs issued in the U.S.) will essentially hardwire a transition to SOFR for FRNs and other financial contracts that do not already have adequate fallback provisions. Similar national legislation has recently passed the U.S. House of Representatives and will move to the Senate for consideration.
We believe that recent developments and the rapid growth of the SOFR market can provide FRN investors with confidence that market participants are taking the right steps to allow for an orderly transition to SOFR. However, it is not possible to predict with certainty how the market will continue to evolve or what the impact will be on existing LIBOR-linked FRNs, including any potential pricing impact associated with the transition. The MVIS US Investment Grade Floating Rate Index is designed to capture the performance of the broad investment grade corporate floating rate note market. The index methodology does not specify that a bond must be LIBOR or SOFR based, and the index composition should reflect the evolving makeup of the overall market over time, including after the LIBOR cessation. FRNs that do not have adequate fallback language may be removed for a variety of reasons; for example, if the notes become illiquid, they may no longer be eligible for inclusion. Importantly, if an FRN effectively becomes a fixed coupon bond due to insufficient fallback language, it would no longer qualify for inclusion. Lastly, to the extent that other alternative benchmarks become more widespread and if issuance grows, they will be increasingly represented in the index.
For further information on the transition away from LIBOR, please see our recent paper.
Q: What is SOFR and how does it differ from LIBOR?
A: SOFR is a broad measure of the cost of borrowing cash overnight collateralized by U.S. Treasury securities. Based on actual repurchase agreement transaction volume of approximately $1 trillion per day, it is, therefore, fully transaction-based, nearly risk-free and provides a good representation of general funding conditions in U.S. money markets. Because it is fully transaction-based and representative of a broad range of market participants (not just global banks), it is protected from the manipulative practices that plagued LIBOR.
SOFR is a fundamentally different rate than LIBOR in several ways, and these differences have an impact on the actual level of the rate. A summary of the two rates is provided below. Most notable is that due to its secured nature using U.S. Treasuries, SOFR is a risk-free rate while LIBOR has always had an embedded credit risk element since it represents unsecured counterparty risk to a large global bank. Being transaction-based, SOFR is a backwards looking rate, whereas LIBOR is forward-looking, and is published in several tenors, including the widely referenced 3-month rate. However, although SOFR itself is an overnight and backwards-looking rate, a burgeoning futures market has recently allowed for the publication of implied, forward-looking term rates based on market expectations of the future path of SOFR. We expect that the term rate could become a widespread benchmark for future FRN issuance.
|Credit Spread||No||Yes – generally a proxy for AA-rated credit risk|
|Basis||All repo transactions from prior day collateralized by U.S. Treasury collateral, excluding special-issue collateral||Average rate at which a large global bank could fund itself in the wholesale unsecured interbank market, calculated from submissions from contributor banks which are based on both actual transactions and “expert judgement”|
|Term||Overnight; however a forward looking term rate based on the SOFR derivatives market has recently developed||Overnight, 1 week, 1 month, 2 month, 3 month, 6 month and 12 months|
|Currency||USD||USD, EUR, GBP, CHF and JPY|
|Rate Determination||In arrears||In advance|
|Administrator||New York Federal Reserve||Intercontinental Exchange (ICE) Benchmark Administration|
Source: New York Federal Reserve and ICE Benchmark Administration
1 Source: Bloomberg. Based on the market value of the Bloomberg U.S. Floating Rate Notes Index.
Bloomberg Barclays US 1-5 Year Government/Credit Index includes treasuries (i.e., public obligations of the U.S. Treasury that have remaining maturities of more than one year) and agencies (i.e., publicly issued debt of U.S. Government agencies, quasi-federal corporations, and corporate or foreign debt guaranteed by the U.S. Government) and publicly issued U.S. corporate and foreign debentures and secured notes that meet specified maturity, liquidity, and quality requirements.
Bloomberg Barclays US Corporate 1-5 Y Index measures the performance of the investment grade, US dollar-denominated, fixed-rate, taxable corporate bond market with maturities of 1-5 years.
MVIS US Investment Grade Floating Rate Index, which consists of U.S. dollar denominated floating rate notes issued by corporate issuers and rated investment grade.
ICE BofA US Broad Market Index tracks the performance of US dollar denominated investment grade debt publicly issued in the US domestic market, including US Treasury, quasi-government, corporate, securitized and collateralized securities.
ICE BofA US Corporate Index tracks the performance of US dollar denominated investment grade corporate debt publicly issued in the US domestic market.
ICE BofA 1-3 Year US Corporate Index tracks the performance of US dollar denominated investment grade corporate debt publicly issued in the US domestic market, with maturities of 1-3 years.
ICE BofA Current 30-Year US Treasury Index is a one-security index comprised of the most recently issued 30-year US Treasury bond.
ICE BofA US Floating Rate Treasury Index tracks the performance of floating rate US dollar denominated sovereign debt publicly issued by the US government in its domestic market.
ICE BofA US High Yield Index tracks the performance of US dollar denominated below investment grade corporate debt publicly issued in the US domestic market.
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June 23, 2022
With higher relative yields, a history of strong risk-adjusted returns, and protection against rising rates, we believe this is a great time to make a strategic allocation to CLOs.