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How Floating Rate Notes Act as Cushions When Rates Rise


Dec. 26 2018, Updated 5:55 p.m. ET


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.

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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.

Market Realist

How are FRNs beneficial during a period of rising rates?

Rising interest rates usually cause fear in the fixed income market, as market interest rates and bond prices move in the opposite direction. Thus, when interest rates increase, prices of fixed-rate bonds fall and vice versa, which is also called interest rate risk. Investors get cautious when market interest rates change, as fixed-rate bonds, which pay a fixed coupon, become less attractive during these times.

However, floating rate investment grade bonds (or FRNs) are different from plain vanilla bonds. These bonds do not pay a fixed rate of interest. They pay a variable rate of interest. This rate is either based on the Federal funds rate or LIBOR (London Interbank Offered Rate) along with an added spread for the added risk. Thus, these bonds act as cushions when market interest rates rise.

Another major advantage of floating rate bonds are the low correlations with other asset classes like stocks and government bonds as shown in the chart above. They thus act as a diversifier, which benefits income investors. To get exposure to floating rate notes, investors can consider the VanEck Vectors Investment Grade Floating Rate ETF (FLTR), whose underlying assets consist of investment-grade bonds, which have a relatively low risk of default, thus offering investors higher credit quality.


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