Protect Against Fed Rate Hikes with Floating Rate Notes
March 16, 2022
Read Time 5 MIN
With nearly seven rate hikes predicted for 2022, investment grade floating rate notes may provide heightened yields while enabling investors to protect their portfolios.
Reducing duration, seeking enhanced yields and targeting less correlated segments of the market are all ways to build a more resilient bond portfolio in the face of rising rates and higher than average inflation. Investment grade floating rate notes (“FRNs”) may be an attractive way to balance these goals and allow investors to protect against rising rates while actually increasing their income as rates go up. The Federal Reserve’s March rate hike this week is the first of several expected over the next year, kicking off the first rate hike cycle since 2018. Although expectations for rate hikes initially declined at the onset of the Russia-Ukraine crisis, expectations are back up and market implied probabilities point to nearly seven increases of the Federal Funds rate through the end of the year, as shown below.
Market Expecting Nearly 7 Rate Increases This Year
Source: Bloomberg as of 3/14/2022.
Indeed, FRNs have performed well year-to-date through February 28 in the face of rising rates, with returns that are approximately flat versus a -3.3% loss in the broad U.S. market (as measured by the ICE BofA US Broad Market Index) and -5.2% among fixed rate corporate bonds (as measured by the ICE BofA US Corporate Bond Index). FRNs have coupons that are based on a short-term base rate such as the London Interbank Offered Rate (“Libor”) or Secured Overnight Funding Rate (“SOFR”) which reflect short-term funding costs, and an additional fixed spread that reflects the credit risk of the issuer. For example, with Libor at 0.50% on February 28, 2022, an FRN with a spread of 0.50% would have an annualized coupon of 1.00% if the coupon reset on that day. If Libor increases to 0.75%, the next coupon would increase to an annualized rate of 1.25%. Because the coupon adjusts as Libor or SOFR increase or decrease, the value of the FRN is insensitive to changes in interest rates (although will still be impacted by changes in market spreads). In a declining rate environment FRN investors will not benefit, but when rates rise, coupons increase and market values remain relatively steady. This is in contrast to fixed coupon bonds, which are negatively impacted by rising rates, as reflected by interest rate duration. Even short-term bonds with maturities of 1-5 years can be significantly impacted by even a modest rise in interest rates.
Significantly Lower Interest Rate Sensitivity
As of 2/28/2022
Source: Bloomberg Barclays, Factset and Morningstar as of 2/28/2022. 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. See fund returns page for performance current to the most recent quarter-end. Past performance is no guarantee of future results. See disclaimers and index definitions at the end of the presentation.
With 3-month Libor rates already reflecting the first expected hikes, FRN coupons are already adjusting upwards. SOFR, given that it is an overnight rate, would reflect the higher rates when they are announced. In both cases, the result is higher yields. To be sure, these short-term funding rates are still at extremely low levels after hovering below 0.30% for nearly 1.5 years, as rates remained depressed and the Fed kept rates post-pandemic rates at zero. Even in the ultrashort, high quality segment of the market, however, there are ways to enhance income. For example, focusing on credit-oriented issuers like corporates, rather than sovereign and agency issuers, can increase the spread and, therefore, overall yield. Further, longer maturity FRNs tend to provide higher spreads, but without adding any additional interest rate risk. The MVIS® US Investment Grade Floating Rate Index builds this longer maturity, credit-oriented tilt into a rules-based methodology resulting in higher overall yields versus other FRN strategies.
Index Design Provides Higher Yield
Source: MVIS, Bloomberg and ICE Data Indices as of 2/28/2022. Enhanced Yield FRN is represented by MVIS US Investment Grade Floating Rate Index; <5 Year FRNs represented by Bloomberg US FRN <5 Year Index; US Treasury FRN represented by ICE BofA All Maturity US Floating Rate Treasury Index. Past performance is not indicative of future results.
The floating rate nature of FRNs means they have low or negative correlation to rate-sensitive fixed income asset classes, such as Treasuries or fixed coupon investment grade bonds. This may allow them to fulfill two primary roles that fixed income can have within a balanced portfolio: income and diversification. Further, this is achieved without adding significant credit risk since the bonds carry investment grade ratings. This is in contrast to leveraged loans, another floating rate asset class, which provide higher yields but with much higher credit risk. With the uncertainty that has impacted the market recently, many investors may find the relative safety of FRNs desirable.
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. FLTR’s index is designed to provide an enhanced yield, which has provided outperformance versus other ultrashort categories.
Performance Relative to the Morningstar Open End Funds – U.S. Ultrashort Bond Category
As of 2/28/2022
|Trailing Returns||1 Year||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 - 12/31/20||Peer group percentile||Peer group rank|
|VanEck Investment Grd FI Rt ETF||0.05||11||27||1.82||8||17||2.02||6||11||1.49||16||14|
|US Fund Ultrashort Bond||-0.24||36||86||1.22||38||82||1.42||46||80||1.04||55||47|
Source: © Morningstar, Inc. All Rights Reserved. Data as of 2/28/2022. 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 244 funds as of 2/28/2022.
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.
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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.
Bloomberg US FRN < 5 Years Index is a subset of the US Floating-Rate Note (FRN) Index, which measures the performance of USD denominated, investment-grade, floating-rate notes across corporate and government-related sectors.
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 All Maturity 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.
MVIS US Investment Grade Floating Rate Index tracks U.S. dollar denominated floating rate notes issued by corporate issuers and rated investment grade.
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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.