A number of factors may combine to increase investor interest in investment grade floating rate notes in the coming months, according to Fran Rodilosso, Fixed Income Portfolio Manager at Market Vectors ETFs.
“Investors seem to be looking for products that can serve as a viable supplement to cash or money market funds, with the latter currently providing virtually no yield,” said Rodilosso. “At the same time, they are also looking for protection against inflation and higher interest rates while worrying about the impact that the Federal Reserve’s ‘tapering’ of its quantitative easing program might have on lower-rated credit products.”
“Each of these concerns could potentially be addressed by investment grade floating rate note funds, which typically trade at a spread over 3-month LIBOR1,” continued Rodilosso. “In a zero interest rate policy environment, that base rate remains quite low, currently at 0.27%2. Taking into account the spread that the investment grade borrowers pay over LIBOR, US-listed investment grade floating rate note exchange-traded funds today are yielding3 between approximately 0.40% and 0.70%.”
“That type of yield is still better than that from money market funds, though with some degree of credit risk,” he added. “However, when short-term interest rates start to rise, the coupons on these notes will adjust, resetting quarterly, which means that the sensitivity of the price of floating rate notes to changes in short-term interest rates is extremely low, as their yield changes via the coupon adjustments rather than via a change in price.”
Market Vectors offers one of the few floating rate note-focused exchange-traded funds (ETFs) in the marketplace with its Investment Grade Floating Rate ETF (NYSE Arca: FLTR), which differs from others in the market primarily in years to maturity, credit quality and yield potential.
“FLTR’s added weighting to maturities beyond two years adds both yield potential and liquidity to the index,” said Rodilosso.
FLTR’s underlying index, the Market Vectors® Investment Grade Floating Rate Index allocates higher weightings to notes with relatively longer maturities (i.e., those between 2 and 5 years) and has a greater concentration within the single-A credit rating4 space. FLTR’s index is also differentiated by requiring issues to have a minimum of six months to maturity for inclusion. Targeting the most liquid notes in this space, the index has a minimum issue size of $500 million.
“FLTR, and another fund in our ETF family, Treasury-Hedged High Yield Bond ETF (NYSE Arca: THHY), are two funds that we have developed with an eye toward providing solutions for investors looking to address interest rate risk,” Rodilosso added.
Rodilosso noted that some of the most popular hedging instruments of recent years, such as TIPS (i.e., Treasury Inflation-Protected Securities), have proven to be vulnerable in a rising rate environment. “TIPS’ principal adjusts with an inflation index; they do not actually protect against interest rates moving higher more rapidly than inflation,” he said. “They also tend to have a very long interest rate duration5.”
Rodilosso added that floating rate notes are not without potential downsides, including a sensitivity to changes in credit spreads; i.e., the amount these investment grade borrowers must pay above LIBOR in order to borrow. He noted, however, that the majority of floating rate note issues are five years and less to maturity and the vast majority of borrowers have single-A credit ratings or better, making the credit spreads of these borrowers potentially less volatile than the credit spreads of high yield borrowers.
Mr. Rodilosso has 20 years of experience trading and managing risk in fixed income investment strategies, including 17 years covering emerging markets. In addition to FLTR and THHY, Mr. Rodilosso also oversees Emerging Markets Local Currency Bond ETF (NYSE Arca: EMLC), Emerging Markets High Yield Bond ETF (NYSE Arca: HYEM), Fallen Angel High Yield Bond ETF (NYSE Arca: ANGL), International High Yield Bond ETF (NYSE Arca: IHY), LatAm Aggregate Bond ETF (NYSE Arca: BONO) and Renminbi Bond ETF (NYSE Arca: CHLC). As of June 30, 2013, the total assets for these ETFs amounted to approximately $2.1 billion.
1London Interbank Offer Rate (LIBOR) refers to the benchmark used by banks, securities houses and investors to gauge the cost of unsecured borrowing in the money markets for various periods of time and currencies. Rates are compiled by the British Bankers’ Association.
2Source: Bloomberg, as of July 11, 2013
330-Day SEC Yield is calculated as of the most recent month end, and is a standard yield calculation developed by the Securities and Exchange Commission that allows for fairer comparisons primarily among bond funds. Figures are based on the 3 US-listed investment grade floating rate note ETFs: Market Vectors Investment Grade Floating Rate ETF (FLTR) at 0.66%, iShares Floating Rate Note ETF (FLOT) at 0.42%, SPDR® Barclays Investment Grade Floating Rate ETF (FLRN) at 0.47%, as of July 10, 2013.
4Credit ratings of A or better are considered to be high credit quality; credit ratings of BBB are good credit quality and the lowest category of investment grade; credit ratings BB and below are lower-rated securities (“high yield”); and credit ratings of CCC or below have high default risk.
5Duration measures a bond's sensitivity to interest rate changes that reflects the change in a bond's price given a change in yield.
About Market Vectors ETFs
Market Vectors exchange-traded products have been offered since 2006 and span many asset classes, including equities, fixed income (municipal and international bonds) and currency markets. The Market Vectors family totaled $21.8 billion in assets under management, making it the seventh largest ETP family in the U.S. and tenth largest worldwide as of June 30, 2013.
Market Vectors ETFs are sponsored by Van Eck Global. Founded in 1955, Van Eck Global was among the first U.S. money managers helping investors achieve greater diversification through global investing. Today, the firm continues this tradition by offering innovative, actively managed investment choices in hard assets, emerging markets, precious metals including gold, and other alternative asset classes.
There are risks involved with investing in ETFs, including possible loss of money. Shares are not actively managed and are subject to risks similar to those of stocks, including those regarding short selling and margin maintenance requirements. Ordinary brokerage commissions apply. Debt securities carry interest rate and credit risk. Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa. Credit risk is the risk of loss on an investment due to the deterioration of an issuer's financial health. The Funds' underlying securities may be subject to call risk, which may result in the Funds having to reinvest the proceeds at lower interest rates, resulting in a decline in the Funds' income.
The Funds may be subject to credit risk, interest rate risk and a greater risk of loss of income and principal than those holding higher rated securities. As the Funds may invest in securities denominated in foreign currencies and some of the income received by the Funds may be in foreign currency, changes in currency exchange rates may negatively impact the Funds’ returns. Investments in emerging markets securities are subject to elevated risks which include, among others, expropriation, confiscatory taxation, issues with repatriation of investment income, limitations of foreign ownership, political instability, armed conflict and social instability. Some Funds are subject to risks associated with investing in high-yield securities; which include a greater risk of loss of income and principal than funds holding higher-rated securities, as well as concentration risk; hedging risk; and short sale risk. Investors should be willing to accept a high degree of volatility and the potential of significant loss. The Funds may loan their securities, which may subject them to additional credit and counterparty risk. For a more complete description of these and other risks, please refer to the Funds’ prospectus and summary prospectus.
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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. Creation units are issued and redeemed principally in kind. Shares may trade at a premium or discount to their NAV in the secondary market.
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