Van Eck is best known in the ETF world for its suite of funds focusing on equities of hard asset producers and emerging markets. But the latest offering from the New York-based issuer targets a corner of the fixed income market that has historically not been readily accessible through exchange-traded products. The new Investment Grade Floating Rate ETF (FLTR) will seek to replicate the Market Vectors Investment Grade Floating Rate Index, a benchmark that consists of dollar-denominated floating rate notes issued by corporations. Component securities must be rated investment grade (BBB- / Baa3) or better by at least one of the three major ratings agencies.
Most corporate debt securities pay a fixed coupon over the term of the issue. Floating rate securities, or “floaters,” feature coupons that are pegged to a reference rate, such as 3-month LIBOR, plus a spread. For example, debt may be issued with a coupon equal to LIBOR plus 200 basis points. If LIBOR is equal to 1%, the coupon on the debt would be 3%. If that reference rate jumped to 2%, the coupon on the security would increase to 4% at the next reset date. Coupons reset periodically, adjusting based on changes in the reference rate. As such, the new floater ETF represents a low risk fixed income alternative that should perform relatively well during periods of rising interest rates.
Slashing Interest Rate Risk
The risk factors associated with investments in fixed income securities generally consists of credit risk and interest rate risk. Credit risk is straightforward; investors must be compensated for the possibility that the issuer will default on their obligations. That explains why yields on junk bonds are higher than yields on investment grade debt, and both are higher than yields on Treasurys [also see Three Short Treasury Bond ETFs To Invest Like Bill Gross].
Interest rate risk relates to the impact that changing rates have on the value of a security. When interest rates rise, existing debt becomes less appealing to investors. That is because higher rates mean that new debt will be issued with increasingly attractive yields–and that the return on outstanding debt becomes less attractive. Suppose you held debt paying 5% annually. If interest rates climbed by 500 basis points, debt of the same credit quality and duration would have to be issued with a 10% coupon. The appeal of your 5% note would drop considerably, since investors would have options for much more attractive yield profiles.
The lower the time to maturity of a debt security, the lower the interest rate risk. Floating rate debt maintains virtually no interest rate risk, as the coupon will mirror changes in interest rates. The adverse impact of rate hikes won’t be felt by floaters, making these securities potentially attractive for investors who are concerned about increases in interest rates. More and more investors are beginning to express anxiety over a climb in interest rates, as the economy shows signs of stabilizing and rising commodity prices have stoked the inflationary flames [see Bond ETFs That Steer Clear Of Interest Rate Risk].
Under The Hood
|Index Vital Stats|
|Average Modified Duration||0.10|
|A or Better||97.9%|
|Number of Issues||188|
The index to which FLTR is linked consists of close to 200 individual securities. Issuers consist primarily of financial firms; this sector accounts for about 95% of assets, with consumer, energy, and communications firms making up the remainder. The average coupon for the related index at the end of the first quarter was 0.91%, and the average yield to worst came in at 1.06%.
The underlying index is market capitalization-weighted, but utilizes a unique scaling methodology based on maturity. The longest third of the portfolio by maturity is scaled to represent about two thirds of total assets, with shorter maturity issues scaled to represent the remaining third. That potentially results in a higher yield for FLTR.
Floating Rate ETFs
Most ETFs in the Corporate Bonds ETFdb Category consist entirely of fixed rate securities; FLTR is the first ETF to offer exposure to floating rate investment grade securities. Earlier this year PowerShares introduced an ETF (BKLN) focusing on senior loans, non-investment grade debt that resets interest rates at regular intervals. Senior loans, also known as bank loans or leveraged loans, are generally extended to companies with a credit rating below investment grade, and are often issued in conjunction with leveraged buyouts or other M&A activities. So FLTR is an investment grade counterpart to BKLN; both products feature minimal interest rate risk, with BKLN offering greater exposure to credit risk (and therefore a higher expected return).
iShares recently detailed plans for a floating rate debt ETF of its own; that proposed product would seek to replicate an index consisting of U.S. dollar-denominated, investment grade floating-rate notes [also see Q&A With Matthew Patterson: Are Bond ETFs Broken?].
The expense ratio for the new ETF will be capped at 0.19% until September 2012. The average expense ratio for the Corporate Bonds ETFdb Category comes in at 0.22%.
Disclosure: No positions at time of writing.