An Investment Grade Solution for Rising Rates
WILLIAM SOKOL: U.S. interest rates have continued their steady climb upwards this year reflecting, among other things, momentum in economic growth. With rates moving up, investors are seeking out ways to reduce their interest rate exposure, as evidenced by substantial inflows into ultra-short duration strategies including floating rate notes.
I'm Bill Sokol, Director of ETF Product Management at VanEck. And here to talk more about floating rate note strategies is Fran Rodilosso, head of our fixed income ETF portfolio management team. Fran, thanks for being here.
FRANCIS RODILOSSO: Thank you, Bill. Thanks for having me.
SOKOL: Fran, given that rates have already moved up quite a bit this year with LIBOR (London Interbank Offered Rate) now at its highest level in a decade, why consider floating rate notes right now?
RODILOSSO: It's really a good question, Bill. Rates are higher than they have been over the last 10 years, but largely because we were in such a period of unprecedented low rates - unprecedented easy monetary policy on a global basis. Many consider us to be still in the early stages, particularly when you look at it globally, not just what the U.S. Federal Reserve (Fed) is doing, but the Bank of Japan, and very eventually, the European Central Bank. Anyway, we're in potentially a prolonged period where rates could be rising or normalizing even.
We're certainly not, from a historical point of view, at a very high level of rates. So, leaving all that aside, rates are still expected to rise regardless. The Fed is showing plans. One more hike this year. Most of the market seems to be fixed around three or four next year. So, the reason number one is rates are still expected to continue to rise. The global growth scenario, the U.S. growth scenario in particular, tends to support further movements toward higher rates. So FRNs (Floating Rate Notes), whose coupons reset quarterly with LIBOR have a duration of 0.12 - virtually zero duration - are still a good response, good protection in your portfolio against those rising rates. And as the underlying assets in an FRN portfolio are investment grade, there's a margin of credit safety. People are concerned about investment grade credit or where we are in the credit cycle in general. But still, investment grade is where people go for more safety versus the high yield portion of the market at this point in time. Yields are currently attractive on FRNs. They do provide a spread over LIBOR, or at least the corporate FRNs do. So, our ETF that we manage, FLTR, the VanEck Vectors Investment Grade Floating Rate ETF, does provide a fairly attractive spread in my mind over LIBOR at this point in time, between 70 and 75 basis points.
SOKOL: Could you give us some more background on the market? How big is it and who's issuing?
RODILOSSO: Sure. Well, FLTR's index for instance, has a market cap of approximately U.S. $330 billion. There are over 300 issuers in that index. This is all investment grade, a very important concept to talk about when you think about floating rate because one of the most popular investment vehicles in recent times has been bank loans or levered loans. And that is the loan market for sub-investment grade issuers.
FRNs trade more like bonds - normal T+2 settlement cycle. And they are issued by investment grade borrowers. One of the main differences from the fixed rate market is the types of issuers though. FRNs tend to be issued by financial companies, mainly banks. So, the index that FLTR tracks is over 70% banks. So the plus side of that is if you have a favorable outlook on banks right now with rates rising, banks have actually been doing fairly well, this might be attractive.
They're also a bit of a diversifier, you have lower exposure to some of the, call it less desirable, or at least the sectors that the market's been more concerned about lately, such as telecom, retail, and, more recently, energy and mining and sectors like that.
SOKOL: You mentioned bank loans, which is another floating rate asset class. There are other low-duration strategies that investors can allocate to, to reduce interest rate risk. Why consider floating rate notes over these other options?
RODILOSSO: Another really good question. You figure to reduce duration in your portfolio, you can either hold cash, or short-term bonds - very short term bonds - or, as we were talking about just a minute ago, you could hold something like levered loans, or bank loan funds. Versus cash, FRNs do provide a healthy yield advantage: I mentioned earlier, currently, FLTR, for instance, 70-75 basis points above LIBOR, which is not insignificant particularly when you look at your money market options. Which are below LIBOR. Short-term fixed rate bonds are an option, with, right now, a small yield pick-up over, say, FRNs. But they still do have duration. Most of those types of products or funds are in a zero to 5-year category. An average duration is closer to 2.5, I believe, in those products.
So you do still have a level of interest rate risk, longer spread risk actually. A little higher sensitivity also to movements in credit spreads in those fixed rate funds versus FRNs. So for marginal yield pickups. So the question is the risk-reward there. You're better off just getting the near zero interest rate duration. Then as I mentioned, bank loans. That's just a question of a credit exposure decision. That's one reason why people may favor investment grade FRNs rather than going farther out the credit curve for definitely a yield pickup. But also, aside from it, the sort of credit aspect, there is the structural aspect. And for many investors, bank loans are attractive. Historically, they've held up well in terms of default rates and recovery rates, but they're still sub-investment grade and they're still loans, particularly in, say, ETF structures having instruments that have longer than the normal T+2 settlement cycle.
They settle by assignment, usually at least a seven day period. That's one of the areas where if the market does grow concerned about the ETF structure, and how it holds up, the vast majority of ETFs have certainly shown to be able to withstand all types of market situations. But there is a settlement/structural mismatch there. Those funds have managed well through periods of volatility to date. So there's a credit question and a structural question on the bank loan side versus FRNs.
SOKOL: Lastly, how can investors use FLTR in their portfolio?
RODILOSSO: Well, it is a way of reducing overall duration in your portfolio for sure. I would consider it not a clean substitute for cash, but a riskier alternative to cash that still is at the safer end of the corporate bonds universe. So, for investors who are thinking, "Okay, I still need some yield. I want to reduce duration," FLTR is a fairly good alternative. If they want to make some riskier bets on certain asset classes, emerging markets debt, for instance, even local currency, or they do like some parts of the high yield market but want to move down the risk curve in other parts - sort of the risk barbell approach - FLTR is to me a fairly good option.
SOKOL: Thanks, Fran, for sharing your perspective.
RODILOSSO: Thank you, Bill. Thanks again.
The views and opinions expressed are those of the speaker and are current as of the video's posting date. Video commentaries are general in nature and should not be construed as investment advice. Opinions are subject to change with market conditions. All performance information is historical and is not a guarantee of future results. For more information about VanEck Funds, VanEck Vectors ETFs or fund performance, visit vaneck.com. Any discussion of specific securities mentioned in the video commentaries is neither an offer to sell nor a solicitation to buy these securities. Fund holdings will vary. All indices mentioned are measures of common market sectors and performance. It is not possible to invest directly in an index. Information on holdings, performance and indices can be found at vaneck.com.
An investment in VanEck Vectors Investment Grade Floating Rate ETF (FLTR) may be subject to risk which include, among others, credit rating downgrades, issuers may be unable and/or unwilling to make timely interest payments an/or repay the principal on its debt, call risk, and interest rate risk, all of which may adversely affect the Fund. The Fund's assets may be concentrated in a particular sector and may be subject to more risk than investments in a diverse group of sectors.
VanEck Vectors Investment Grade Floating Rate ETF is not sponsored, issued or advised by Wells Fargo & Company, Wells Fargo Securities, LLC or any of their affiliates. The MVIS US Investment Grade Floating Rate Index is the exclusive property of MV Index Solutions GmbH (a wholly owned subsidiary of the Adviser), which has contracted with Wells Fargo to create and maintain and with Interactive Data Pricing and Reference Data, LLC to calculate the Index. Neither Wells Fargo nor Interactive Data Pricing and Reference Data, LLC guarantees the accuracy and/or completeness of the Index or of any data supplied by it or its agents or makes any warranty as to the results to be obtained from investing in the Fund or tracking the Index. The Index is calculated by Interactive Data Pricing and Reference, LLC, which is not an adviser for or fiduciary to the Fund, and, like Wells Fargo, is not responsible for any direct, indirect or consequential damages associated with indicative optimized portfolio values and/or indicative intraday values. The VanEck Vectors Investment Grade Floating Rate ETF is not sponsored, endorsed, sold or promoted by MV Index Solutions GmbH and MV Index Solutions GmbH makes no representation regarding the advisability of investing in the Fund.
Index returns are not Fund returns and do not reflect any management fees or brokerage expenses. Investors can not invest directly in the Index. Returns for actual Fund investors may differ from what is shown because of differences in timing, the amount invested and fees and expenses. Index returns assume that dividends have been reinvested.
Fund shares are not individually redeemable and will be issued and redeemed at their NAV only through certain authorized broker-dealers in large, specified blocks of shares called "creation units" and otherwise can be bought and sold only through exchange trading. Shares may trade at a premium or discount to their NAV in the secondary market. You will incur brokerage expenses when trading Fund shares in the secondary market. Past performance is no guarantee of future results. Returns for actual Fund investments may differ from what is shown because of differences in timing, the amount invested, and fees and expenses.
The performance data quoted represents past performance. Past performance is not a guarantee of future results. 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 at our website.
Investing involves substantial risk and high volatility, including possible loss of principal. Bonds and bond funds will decrease in value as interest rates rise. An investor should consider the investment objective, risks, charges and expenses of the Fund carefully before investing. To obtain a prospectus and summary prospectus, which contains this and other information, call 800.826.2333 or visit www.vaneck.com/etfs. Please read the prospectus and summary prospectus carefully before investing.
No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission of Van Eck Securities Corporation. © Van Eck Securities Corporation.
Van Eck Securities Corporation, Distributor
666 Third Avenue, New York, NY 10017