Considering the Implications of FLOT

 |  Includes: CSJ, FLOT, LQD
by: David Ott

Several articles have described the features of the new iShares Floating Rate Note (NYSEARCA:FLOT) fund, so I thought it would be interesting to look at one of the potential uses for the fund.

Assume for a moment that you own the Barclays 1-3 Year Credit Bond Fund (NYSEARCA:CSJ) because you wanted credit exposure and a relatively short duration because you are concerned about rising interest rates. According to the iShares website, the average yield to maturity for this fund is 1.26 percent and the effective duration is 1.84 years.

With the introduction of FLOT, which has an average yield to maturity of 0.82 percent and an effective duration of 0.12, it is possible to use a "barbell" approach with the iShares iBoxx Investment Grade Corporate Bond Fund (NYSEARCA:LQD) to achieve the same duration with a slightly higher yield.

According to the iShares website, the average yield to maturity for LQD is 4.08 percent and the effective duration is 7.17 years (as of June 23 and 24, respectively). It is possible to exactly match the duration of CSJ with an 84 percent weight in FLOT and a 16 percent weight in LQD, and there is a small pick-up in average yield to maturity of eight basis points.

Of course, these extra basis points don’t represent a free lunch; there is more credit risk in the barbell portfolio than in CSJ. For example, there is much greater concentration in financials: 28.7 percent in CSJ and 48.2 percent in the barbelled mix of FLOT and LQD.

There are benefits too, though. First, there is a slight reduction in explicit costs since LQD has a 15 basis point OER and FLOT and CSJ are both 20 basis points. Using the barbell shaves four basis points off of the expense ratio, which is small in absolute terms but still represents a 20 percent reduction.

Another key benefit is that the convexity profile of the barbelled portfolio is an improvement over just owning CSJ. Convexity measures the sensitivity of the duration of a bond or bond portfolio and a barbelled approach has been shown to offer a better convexity profile than a single maturity portfolio.

This kind of fine tuning isn’t right for everyone, but having FLOT as a tool is a useful contribution to the fixed income ETF arsenal.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: The views expressed do not necessarily represent the views of Acropolis Investment Management, LLC. or its members. Clients of Acropolis own CSJ as a core holding and we are regularly buying and selling CSJ for clients as part of our portfolio rebalancing.