I am asked occasionally about floating rate funds whenever the prospect of higher rates heats up. This article will provide a summary of my top choices in that area, both of preferred stock and bond funds.
The market has been waiting for the Fed to raise rates for years. When it actually will act is unknowable; it may not raise for some time. However, many investors want both the regular income and safety of bonds and bond equivalents, along with the security of knowing that their principal won't suffer unduly should rates rise because the fund components will adjust.
Before getting into the specific choices, I will briefly run through some of the factors affecting bond-type funds in general.
Major Considerations in Choosing a Floating Rate Fund
Floating rates mean that the rates can fall as well as rise. The rates also may not respond with alacrity. Choosing floating rates is not a panacea for bond investors, but rather adding a level of insurance against the future, which can cost you as much as it pays you.
No one should invest in any asset class unless they are knowledgeable about the risks. Before purchasing shares in any fund, a careful review of the fund documents, along with other due diligence, is mandatory for any prudent investor. Every security has specific risks that should be understood before they damage your portfolio when you least expect it.
This is not the place for an extended primer on bonds, preferred stock and the consequences of interest rate changes. I will not even attempt it, because any partial explanation can be misleading in one way or the other. College libraries are full of learned tomes on the subject. However, a brief overview of the interest rate landscape as I write this will help orient investors who may be unfamiliar with it.
Higher yields are attractive, but to get them, you need to take on more price risk. That risk is silent, and isn't something that you notice until it hurts your portfolio.
The primary reason for most investors to choose a floating rate bond over a fixed rate one is to hedge against higher interest rates. The long-term trend of US interest rates over the past 35 years, though, is lower, so that hasn't been a good bet over long periods of time.
The trend also has been lower over the past few years despite continual fretting in the media about higher rates.
The same trend is observable over time in corporate bonds, whose yields still have not hit the historic lows of the 1950s.
On the other hand, inflation adjusted bond yields have risen slightly recently.
US rates also may seem extremely low already, with nowhere to go but up. However, the US is part of a global economy and not immune to its effects. US rates today are higher than those in much of the industrialized world, as shown in the chart below. The carry trade, as it is called, can arbitrage rates across national boundaries with the press of a few buttons, and higher rates in the US cause massive inflows of cash to the US from overseas. This flow tends to strengthen the dollar, curb inflation, cost the US economy export-related jobs and generally work against the Fed's dual mandate. As I discussed here, these are key considerations for the Fed. For these among many other reasons, some market participants such as myself do not expect rates to rise in 2015.
Opinions always differ about where rates are headed, no one has "the answer," and each investor must make his or her own calculation. There also are various strategies that can minimize rate risk, but buying bond products is usually a directional bet on lower interest rates.
Floating Rate Bonds
Floating-rate bonds have coupons that reset regularly. This is based on some index or other metric, such as the yield of a treasury bond of a certain length of time. As shown above, the trends in rates have been lower over time, so the amount paid in those coupons has trended lower as well. In addition, the net asset values will fluctuate:
- From an interest-rate-only standpoint, owning a floating-rate note tied to some short-term measure such as a 90-Day Treasury Bill Discount rate, Libor or a one-year T-bill will provide more income in a rising-rate environment;
- There are credit risk and credit duration concerns. While floaters tend to perform well in rising-rate environments, the credit duration exposure can cause these ETFs to lose value.
The bottom line is that this is a very complex field, with many obvious and not-so-obvious variables and risks. There are many technical considerations that may cause floating-rate bonds to perform contrary to what you might expect. This can be frustrating, so the more you know in advance, the better.
Even if the Fed raises rates, which it can only influence at the short end of the yield curve, the rest of the bond market that is controlled by the market may not react in the same manner. It is not too unusual for the Treasury to raise short rates while the market works contrary to it and actually lowers long rates. This has led to inverted yield curves about once a decade, meaning the long (duration) end of the bond curve has lower rates than the short end of the curve.
Inverted curves are ominous. They generally indicate that the Fed has made a big mistake. An inverted yield curve is a common precursor to recessions (an inverted yield curve preceded the recession of 2008-2009). The market, not the Fed, is the ultimate decision-maker on where rates go in the long term. A weak economy would likely send rates lower as more cash needs to be put to work, while higher inflation and a strong economy (which tend to go together) could send rates higher.
The US Treasury saw the demand for floating bonds some time ago, and in early 2014 began issuing two-year floating-rate notes. These gave investors another option in the already diverse world of bonds and led to creation of a number of new funds to take advantage of that fact. Treasuries are considered to be about as risk-free as is possible, and accordingly tend to pay the lowest coupon amounts, but combining inherent treasury bond safety with the added insurance of floating yields provides what some people consider maximum investment security.
In terms of preferred stock funds, I recently wrote an article about iShares U.S. Preferred Stock (NYSEARCA:PFF), which I own. I go through a discussion there that may be useful for anyone unfamiliar with preferred stock funds. In essence, preferred stock combines attributes of stocks (risk) and bonds (income) that some may find attractive. PFF has about 60% of its preferred stock holdings in variable rate instruments, so it also may be a good candidate for those looking for a variable rate security in addition to the ones discussed in this article. The purer plays are listed below.
Now, let's look at some floating-rate funds in no particular order. As always, any individual fund should be used only as part of an otherwise diversified portfolio.
1. PowerShares Variable Rate Preferred Portfolio
The PowerShares Variable Rate Preferred Portfolio (NYSE:VRP) is a preferred stock fund from Invesco. It is based on the Wells Fargo® Hybrid and Preferred Securities Floating and Variable Rate Index. It invests in corporate securities primarily from the financial sector.
The fund began trading on 1 May 2014. Since then, the price has trended lower during a volatile time for interest rates. It currently pays a SEC 30-day yield of 5.21% and a 12-month distribution rate of 4.99%. Relative to other investments, it hasn't done that poorly, as shown in the chart below.
VRP performance relative to peers. Source: Invesco.com.
The fund's price has suffered in particular during the second half of 2015, when there were many fears of a Fed rate hike. That illustrates the fact that floating yields do not prevent NAV declines. However, the decline isn't as great as the scale of the below chart might suggest.
VRP price performance since inception to 15 October 2015.
For the life of the fund, from 1 May 2014 to 14 October 2015, despite its price fluctuations, VRP's annualized rate of return was 2.78%. That's not much above a 10-year Treasury bond, but you aren't locked in for 10 years with VRP, either. It also is the highest annualized return of all the funds being considered in this article, so everything is relative. The expense ratio is 0.50%, which isn't the lowest you will find, but it also isn't the highest; you have to weigh that against what you get for the expense. This is a solid choice if you want to diversify into preferred shares.
2. Market Vectors® Investment Grd Fl Rt ETF
The Market Vectors® Investment Grd Fl Rt ETF (NYSEARCA:FLTR) follows the Market Vectors® US Investment Grade Floating Rate Index. It invests primarily in the preferred stock of major US corporations, but also has a large overseas component.
FLTR components. Source: Usnews.com. Updated 14 October 2015.
FLTR began trading on 25 April 2011. Since then, it has held its value quite well. The 12-month yield is 0.66%.
FLTR chart from inception in 2011 to 15 October 2015.
The Gross Expense Ratio for FLTR is 0.40%, which is fairly average for these products. What makes FLTR stand out is the diversification it provides.
Since inception, FLTR has produced an annualized rate of return of 0.59%. That is a low rate of return, but if you time it right, you might get lucky with better returns.
3. iShares Floating Rate Bond ETF
The iShares Floating Rate Bond ETF (NYSEARCA:FLOT) tracks an index of short-term corporate bonds with durations between one month and five years.
FLOT components. Source: ishares.com.
FLOT, like FLTR, also is nicely diversified within its limitations. As with many of these funds, is primarily based on bank securities.
FLOT has held its value well over time since it began trading on 14 June 2011. Its 30-day SEC Yield is currently 0.68%, with a trailing 12-month yield of 0.49%.
The expense ratio is 0.20%, which is better than some others on this list. Annualized total return since inception has been 0.75%, which is not bad considering the price stability.
4. SPDR® Barclays Investment Grd Fl Rt ETF
The SPDR® Barclays Investment Grd Fl Rt ETF (NYSEARCA:FLRN) tracks the performance of the Barclays U.S. Dollar Floating Rate Note < 5 Years Index. It shows good diversification across sectors and national boundaries.
FLRN components. Source: Usnews.com.
The inception date was 30 November 2011. FLRN has a 30-day SEC yield of 0.69%.
FLRN chart, inception to 15 October 2015.
Expenses are 0.15%, which is toward the lower range of these types of funds. Annualized gain since inception is 1.19%, which is not bad at all and better than a typical bond fund. Overall, if don't want to invest in preferred stock but want to stick with bonds, FLRN is not a bad choice.
5. BlackRock Float Rate Strat
The BlackRock Float Rate Strat (NYSE:FRA) aims to maximize returns with "a diversified, leveraged portfolio consisting primarily of floating rate debt securities and instruments." The portfolio is located 87.6% in the United States, with the remainder in other industrialized countries.
FRA top components. Source: Blackrock.com.
Given that FRA does not passively track an index, it has high cost of management, with a management fee of 1.03% and expense ratio at 1.48%. These figures are by far the highest of the funds being considered here, which raises a red flag with many investors. However, that does not necessarily mean it should be disqualified from consideration, as it all depends upon whether the performance justifies the fees. The distribution rate is 5.74%.
Price perfomance has been weak over time.
FRA Chart since inception to 15 October 2015.
FRA has the longest history of any of the funds under consideration, as it began trading on 31 October 2003. Annualized total return since then is 1.19%, which included a complete economic cycle. Its performance fluctuates both against itself and its peers, as the following chart shows.
Given the big swings in value, FRA appears to be best suited to a trader who tries to time the swings between discount and premium to book value.
Source: Blackrock.com Fact Sheet.
As the chart suggests, if you time it right, you can buy FRA at a discount to book value and then (hopefully) sell at a premium. Currently, it trades at a nice discount, but that is no guarantee that it will return to a premium any time soon.
This overview of floating rate funds was not meant to be exhaustive. Each fund has its own peculiarities that deserve closer inspection before risking your investment dollars. Instead, the purpose was to create a starting point for those intrigued by the idea of side-stepping the much-feared Fed rate hike cycle that many anticipate.
It would be easy to pick out one fund and claim it is "the best" or "my favorite," but they are all useful in different way to different people. For instance, FRA likely will not be attractive to a conservative investor seeking stability and security of principal. For a more aggressive investor, though, there is the opportunity to profit from the swings relative to book value. VRP, on the other hand, has given investors solid returns, but it does not have a very long track record. The important thing is that you decide what is important to you, and then invest accordingly.
Disclosure: I am/we are long PFF.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.