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

“These managers are careful about valuations,” says Morningstar’s Bush in reference to the Eaton Vance Floating-Rate Fund. “The fund has a relatively low weighting in CCC-rated bonds.” The Morningstar team is working to rate more  floating rate bond funds in response to strong investor demand, Bush notes.

Beth MacLean, executive vice president and portfolio manager for Pimco’s $2.4 billion Senior Floating Rate Fund A (PSRZX) (not yet rated by Morningstar), explains that her fund concentrates on the higher-quality credits in the universe of 1,000+ companies issuing floating rate debt. Since almost all the issuers are non-financial companies, she notes, floating rate funds can also provide diversification  for investors already exposed to credit in the banking and financial sector.

“We have a higher concentration in higher-quality loans,” MacLean says. PSRZX yields 3.2% net of a 1% annual expense charge.

The newest risk to floating rate funds stems from their growing popularity. “As we have seen in the past, when fixed income categories have huge inflows terms can begin to shift more in the issuer’s favor,” says Morningstar’s Bush. But, she says “if you think the economy is going to improve and you are worried about your fixed income exposure, floating rate funds are an option.”

Target maturity bond ETFs, first available in 2010, offer a liquid, diversified option for generating above-Treasury yields while waiting for interest rates to rise. For instance, Guggenheim offers 18 “BulletShares” funds, maturing from 2014 to 2022, tracking either corporate bond or high-yield corporate bond indexes.

Advisors have always laddered bonds by maturity date to help clients manage cash flow and interest rate re-investment risk. The target date bond ETFs—municipal, high-yield and corporate—invest in portfolios of bonds that all mature within the same year. This is a laddering option that reduces credit risk through diversification, yet offers a near-predictable yield to maturity and return of principal.

“Most investors don’t want to hedge their bond exposure in the futures market,” says WisdomTree’s Harper. “Right now, we’re potentially at the end of a 30-year bull market in bonds. We saw a need for investors to hedge interest rate risk.”

WisdomTree’s zero- and negative-duration bond ETFs yield the coupon of the Barclays U.S. Aggregate Bond Index or the BofA Merrill Lynch 0-5 Year US High Yield Constrained Index minus management fees and a cost for interest rate hedges by shorting Treasury futures. The zero-hedge ETFs, AGZD and HYZD, aim to neutralize interest rate risk to principal.

The negative-duration products, AGND and HYND, are designed to rise in value if interest rates rise. AGND, WisdomTree Barclays U.S. Aggregate Bond Negative Duration Fund, has a 2% SEC yield and its price, $49 on March 24, would rise if interest rates on long-term government bonds rise. AGND can be added to a fixed income portfolio as a hedge against rising rates. 

Fear of Bonds 2013 Redux

These products are new and generally untested. But Federal Reserve Chair Janet Yellen’s press conference in mid-March has lit a fire under fixed income investors walloped by poor bond returns last year.

“Since Janet Yellen spoke in March,” says Harper, “a sense of urgency is back among fixed income investors and interest in hedged bond funds has increased.”

Pimco’s MacLean has seen similar recent interest in floating rate funds. “We’ve seen a lot of interest because of the rising rate environment,” she says.

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