The latest addition to the fast-growing ETF lineup is a fund from State Street that will offer exposure to investment grade debt that adjusts interest payouts based on prevailing market conditions. The SPDR Barclays Capital Investment Grade Floating Rate ETF (FLRN) is linked to an index that consists of investment grade debt with a floating interest rate, meaning that the component securities will make interest payments that are based on the value of a specified reference rate. The underlying index consists primarily of debt instruments that pays a variable coupon rate based on 3-month LIBOR, plus a fixed spread that can vary from bond to bond.
Case For “Floaters”
With interest rates continuing to hover near historical lows, investors have become increasingly focused on floating rate debt. That’s because floating rate debt generally exhibits very low sensitivity to interest rate movements, since the payout investors will receive will move in unison with any adjustment. Fixed rate debt, on the other hand, can see its value impacted significantly by rate movements; interest rate hikes tend to lower values of existing debt, since the appeal of already-issued securities is diminished relative to new debt being issued.
Though most investors don’t expect interest rates to begin climbing anytime soon, they are aware that there is no room for further declines; most of the key benchmark interest rates are at or near zero. For those concerned about the adverse impact of rate hikes on bond valuations, floating rate funds can be a way to reduce those sensitivities while still capturing some return [see Interest Rate Risk Makes Big Payouts].
Because floating rate debt doesn’t feature much in the way of interest rate risk, it can be expected to deliver lower yields than otherwise similar fixed rate securities. The iShares Barclays Aggregate Bond Fund (AGG), for example, has a 30-Day SEC Yield of about 2.1%. AGG’s effective duration is about 4.5 years, whereas the effective duration for most floating rate funds is close to zero. According to the FLRN fact sheet, the underlying index has a yield to worst of about 1.66%.
Under The Hood
The index that FLRN seeks to replicate consists of about 320 securities, including bonds from government agencies and corporate debt. About three quarters of the benchmark consists of bonds from corporate issuers, with financial institutions accounting for the lion’s share of that total. Though the index includes only dollar-denominated debt, many of the issuers of the component securities are international; Royal Bank of Scotland, Danske Bank, and Toronto Dominion Bank are all behind some of the debt in the FLRN portfolio.
Floating Rate ETFs
The majority of bond ETFs available to U.S. investors are dominated by debt that issues a fixed interest payment; floating rate bond ETFs are a relatively new innovation. There are a number of floating rate bond ETFs now on the market, including the iShares Floating Rate Note Fund (FLOT) and Market Vectors Investment Grade Floating Rate Bond Index Fund (FLTR). Both of those ETFs will be generally similar to the recently-launched FLRN, focusing on investment grade debt that generally makes interest payments based on LIBOR.
Disclosure: No positions at time of writing.