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Continuing a recent trend on the fixed income side of the ETF arena, iShares announced the launch of an ETF that offers exposure to floating rate debt. The new Floating Rate Note Fund (NYSEARCA:FLOT) will seek to replicate the Barclays Capital U.S. Floating Rate Note < 5 Years Index, a benchmark that includes about 300 dollar-denominated, investment grade floating rate debt securities with less than five years remaining to maturity.

Most bond ETFs contain fixed rate bonds that pays a predetermined coupon over the life of the obligation. That exposes investors to interest rate risk; rising rates make existing debt less attractive compared to new debt being issued with higher coupon rates (conversely, rate cuts enhance the yield profile of existing products). The coupon rates for floating rate debt are generally set relative to a reference rate; for example, a security may pay a coupon equal to 3-month LIBOR plus 200 basis points. So coupon payments move in unison with changes in interest rates, effectively removing the risk associated with unexpected moves in rates.

The return offered by fixed income products generally depends on the amount of exposure to two risk factors: credit risk and interest rate risk. Credit risk relates to the likelihood that the issuer will default on their obligations, leaving bondholders empty handed (or with only a portion of the fair value of the debt). Interest rate risk is determined by the effective duration of the debt securities. The longer a fixed coupon rate is set (i.e., the longer the time until maturity), the greater the sensitivity to changes in interest rates. So a fund like the Barclays 20+ Year Treasury Bond Fund (NYSEARCA:TLT) has minimal credit risk–the underlying securities are backed by the U.S. government–but significant interest rate risk, since the holdings have at least 20 years until maturity [Advanced Bond ETF Investing].

FLOT is near the other corner of the risk continuum; investors take on little in the way of interest rate risk, since the coupon payments reset at regular intervals. The exposure to credit risk creates a yield that is significantly higher than money market-like ETFs such as MINT or BIL. So a fund like FLOT might be appealing to an investor who expects interest rates to rise, and is concerned about the adverse impact that development would have on prices; it allows investors to generate returns through the exposure to credit risk, but should feel very little impact from any decisions made by the Fed at upcoming meetings [Ten ETFs To Own When The Fed Raises Rates].

"FLOT can serve several roles in an investor’s portfolio," said Matt Tucker, iShares Head of Fixed Income Strategy at BlackRock. "It can provide investors with an opportunity to reduce exposure to interest rate risk in the portfolio. In addition, it can serve as a diversifier within traditional fixed income, as well as multi-asset class portfolios. Investors can also use FLOT to gain exposure to credit with less interest rate exposure or as a complement to other short duration strategies."

Floating Rate Bond ETFs

FLOT Vital Stats
Wtd. Avg Maturity* 1.87 years
Wtd. Avg Coupon* 0.83%
Avg. YTM* 0.74%
Effective Duration* 0.12 years
Expense Ratio 0.20%
*Reflects underlying index as of 5/31/11

iShares becomes the latest issuer to debut a product offering exposure to floating rate debt; already in 2011, Van Eck introduced the Market Vectors Investment Grade Floating Rate Bond ETF (NYSEARCA:FLTR). That fund is linked to an index that consists of investment grade floating rate corporate debt, giving it a generally similar risk/return profile to FLOT. PowerShares also recently launched its Senior Loan Portfolio (NYSEARCA:BKLN), an ETF that holds institutional leveraged loans. Those debt securities, generally issued by companies with credit ratings below investment grade, also strip out interest rate by regularly resetting coupon rates based on a reference interest rate benchmark.

While all the component securities of FLOT are denominated in U.S. dollars, the issuers represent a number of different countries. About half of the portfolio consists of debt from U.S. companies, with Australia (11%), the U.K. (10%), France (7%), and the Netherlands (5%) also receiving meaningful allocations (in total more than a dozen countries are represented). The effective duration of the underlying index comes in at just 0.12 years, indicating the extent to which interest rate changes will have an impact on the value of the underlying securities.

By comparison, the iShares Barclays 1-3 Year Credit Bond Fund (NYSEARCA:CSJ) has a duration of about 1.9 years and an average yield to maturity of about 1.26%. That fund, which holds fixed rate investment grade debt, features a slightly higher return (along with more significant interest rate risk).

Disclosure: No positions at time of writing.

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Source: iShares Launches Floating Rate Fixed Income ETF