Interest rates were bound to rise from their mid-2012 low of 1.5% on the 10-year bond. But the intensity of the increase that began last May, when the rate shot up from 1.7% to 3% in less than seven months, took most investors and financial advisors by surprise. This year’s tame first quarter provided breathing room to reconsider fixed income portfolios, especially in light of new products designed to help meet the current challenge: Managing the “safe” portion of a balanced portfolio to provide a yield that doesn’t lag inflation and leaves firepower to buy if interest rates do rise.
“Right now, you have a choice between zero return in cash or current income with principal risk” in traditional high-grade fixed income securities, says Steve Baker, president of Investors Capital Management in Darien, Conn.
In addition to traditional solutions such as raising cash, buying Treasury Inflation Protected Securities (TIPS) and shortening durations, new fund products offer other options—many previously available only to institutional investors—to protect against principal loss in a rising rate environment.
For starters, in January the U.S. Treasury launched Treasury Floating Rate Notes (FRNs). These notes represent the first new product from the Treasury since January 1997, when it launched TIPS. Now a $750 billion market, TIPS remain a popular way to invest in longer-term U.S. government bonds with inflation protection. The new floating rate notes, sold in denominations as low as $100, have a two-year duration and are issued each month. The notes pay interest based on the 13-week Treasury bill auction plus a spread. Unfortunately, the current Treasury bill rates are barely above zero. But if short-term interest rates rise, the interest payment on FRNs resets to track the rise. If the Federal Reserve embarks on a steady “normalization” of short-term interest rates—say 25 basis points starting sometime in 2015—investors in FRNs participate.
Exchange-traded funds (ETFs) for these FRNs have sprung up since the first auction, offering investors easy daily access to the notes. The first to launch, iShares Treasury Floating Rate Bond ETF (TFLO) and WisdomTree Bloomberg Floating Rate Treasury Fund (USFR), charge .15% management fees. But BlackRock will waive the management fee for TFLO for the first year because the interest rate on the notes does not cover the fee. This product is likely to become a mainstay for investors parking cash short term, and may gain popularity as a likely interest rate increase by the Federal Reserve becomes imminent.
“The Floating Rate Note market could become as big as the TIPS market over time,” says Rick Harper, head of fixed income and currency at WisdomTree.
Still, it is early days; assets as of the end of March amounted to $5 million for TFLO and $2.5 million for USFR.
Just a Pretty Face?
Floating rate loans—aka bank loans, leveraged loans or senior loans—consist of secured corporate debt issued by below-investment-grade borrowers. The loan coupons adjust every 40 to 60 days based on the London Interbank Offered Rate (LIBOR), or a pre-set floor, plus a spread. The spread, at least 2.5% above a typical 1% floor, makes for high current income. These attractive yields and floating rate features drew enormous investor attention last year, according to Morningstar. Fund inflows were $62 billion in 2013 compared with $11.6 billion in 2012. The floating rate loan market amounts to about $700 billion, according to Eaton Vance (based on data from S&P).
But Morningstar Senior Fund Analyst Sarah Bush warns, “The reason you are paid that attractive yield is because these are risky companies—junk-rated companies.”
The same strengthening economy that boosts interest rates also benefits sales and profits of many issuers, while the floating rate feature pays investors higher yields as rates increase. For this reason, bank loans have historically performed well when rates rise. The B-rated and BB-rated issuers tend to be household names such as Heinz, Hilton Worldwide, Gardner Denver, HCA, Chrysler, Clear Channel Communications and Dell Computer, almost all in industrial and consumer categories.
Fund managers provide expertise and diversification to offset much of the credit risk, holding 200 or more positions in many popular funds. The Eaton Vance floating rate Fund A (EXBLX) has $15 billion in assets, yielding 3.85% as of the end of February 2014. It’s annual expense ratio is .99%, it turns over about one-third of its portfolio annually and the majority of its credits are single- or double-B rated. EXBLX is the only fund in this category rated Gold by Morningstar.
Demand on the Rise
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