With interest rates at historic lows, investors are looking to floating rate bond funds as a way to help protect portfolio value as interest rates rise. The proof is in the numbers: investors allocated $9.2 billion to floating rate ETFs in 2013, including $3.1 billion into the iShares Floating Rate Note ETF (NYSEARCA:FLOT).
Luckily for investors, a new type of floating rate security just hit the market. On January 29th the U.S. Treasury issued $15 billion of its first floating rate Treasury bond. It's the first time the U.S. Treasury has issued a new security type since 1997, when they introduced Treasury Inflation Protected Securities (TIPS). These new floating rate notes are designed to pay more interest to the bondholder if short term Treasury yields rise.
Each new floating rate Treasury bond will have a final maturity of 2 years at issuance. The coupon rate paid will be a spread over the most recent 13-week Treasury bill auction rate, and will be re-set each week. For example, when Treasury Floating Rate Notes were first issued, the spread was set at 0.045%. The yield on the Treasury bill index was 0.055%. This means that for the first week of issuance, the bond will pay an interest rate of 0.10% annualized. When 13-week Treasury bills are auctioned again the following week, the coupon rate will reset to 0.045% plus the new auction rate. Interest rates on floating rate Treasuries rise and fall as the T-bill rate increases or decreases. The chart below shows the history of the 13-week T-bill rate versus the Federal Funds Target rate. As you can see, the T-bill rate moves along with changes in the Fed Funds rate. As we don't expect the Fed to raise the Fed Funds rate in the near term, it is likely that T-bill rates will also remain low. When economic activity picks up and the Fed begins to raise rates, that is when we would expect the coupon rate on Treasury Floaters to rise.
Investors seeking exposure to Treasury floaters can buy them in the secondary market or directly from the Treasury. They can also buy them through the new iShares Treasury Floating Rate Bond ETF (NYSEARCA:TFLO). Some investors wonder why they would consider using an ETF to access the Treasury market instead of buying the bonds themselves. As the over $40 billion in Treasury iShares ETFs suggest, the ETF structure offers some advantages over individual bonds.
- Ease of trading: iShares ETFs can be bought and sold like a stock, a much less cumbersome process than the over the counter bond market. Securities purchased directly from the US Treasury may need to be moved into a brokerage account before you can sell them, adding another step to the process and slowing down execution.
- Professional management: an index iShares ETF seeks to track its stated benchmark, reinvesting proceeds from maturities and purchasing new securities that are issued.
- Regular income: iShares bond funds typically make monthly distributions of income, as opposed to the quarterly or semi-annual schedules for Treasury securities.
- Transparency of pricing: if you can get a stock quote, you can get a quote on the price of your ETF. This makes it much easier to track your investment.
In terms of other U.S. Treasury securities, my colleague Russ Koesterich says in his latest Investment Directions that it's wise to avoid intermediate duration at this time - specifically five year Treasuries and TIPS. Consider sticking to very short and longer-duration fixed income investments. And if you choose to stay short, take a look at the new floating rate Treasuries.
Securities with floating or variable interest rates may decline in value if their coupon rates do not keep pace with comparable market interest rates. Narrowly focused investments typically exhibit higher volatility. The Fund is subject to credit risk, which refers to the possibility that the debt issuers will not be able to make principal and interest payments or may have their debt downgraded by ratings agencies. The Fund's income may decline when interest rates fall because most of the debt instruments held by the Fund will have floating or variable rates. An investment in the Fund(s) is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency.