Drawing derision from President Trump, the Federal Reserve declined to lower interest rates last month and in what amounts to a good news/bad news scenario, the June jobs report (good news) was stronger-than-expected, implying the central bank won’t need to pare rates this month.
So it’s possible that “higher for longer” could be the order of the day for interest rates. That appears to be the case despite Trump’s push to replace Fed Chairman Jerome Powell. So with neither higher for longer nor Powell likely not going anywhere for awhile, advisors may want to examine the “hotter for longer” fixed income trade: floating rate notes (FRNs).
“Hot” may be doing “floaters” a disservice. For the five years ending July 8, the largest FRN exchange traded fund not dedicated to collateralized loan obligations (CLO) returned 18.9% while the Bloomberg US Aggregate Bond Index slumped 4.8%. That speaks to the efficacy of FRNs and the related ETFs in rising rate environments.
On that note, the good news for advisors is that explaining the plumbing of FRNs to clients is easy. Put simply, these bonds reset their coupons based on short-term rates, meaning they’re less vulnerable to rate hikes and thus deliver not only protection, but the potential for outperformance when borrowing costs are elevated.
Floaters Can Be Fantastic
Well, they already have been. Just look at the $2.44 billion VanEck IG Floating Rate ETF (FLTR). That ETF returned 21.3% over the past five years while delivering annualized volatility that was barely more than a third of that of “the Agg.” As its name implies, FLTR holds investment-grade debt, so clients aren’t exposed to significant credit risk with this fund.
“Importantly, FRNs typically carry investment grade ratings, making them a good choice for investors who want yield without chasing lower-quality credit risk—a contrast to leveraged loans or high yield bonds,” notes William Sokol of VanEck. “With their low correlation to rate-sensitive assets, FRNs can fulfill the twin objectives of fixed income: income and diversification.”
Something else advisors know – and it's worth mentioning in client conversations – is that the bond market epitomizes the notion that are no free lunches in financial markets. Want a higher yield? You'll have to take more credit or rate risk. Want to eliminate or mitigate those risks, you're going to get a lower yield.
In the case of the aforementioned FLTR, rate risk is essentially non-existent and credit risk is minimal. However, FLTR, which turned 14 years old in May, doesn’t cheat investors out of income as highlighted by a 30-day SEC yield of 5.02%.
FLTR’s Moment Could Be Extended
As Sokol notes, floaters “offer a rare combination of yield, resilience, and diversification.” Those are coveted traits for fixed income investors in any environment, but particularly in the current climate because a confluence of factors arguably indicates the Fed may be wise to be measure when it comes to rate cuts.
“Even as rate hikes appear to be behind us, the ‘all-clear’ signal for long-duration fixed income hasn’t arrived. With inflation proving sticky and the front end of the curve still offering high yields, investors are remaining cautious about adding duration risk,” he notes.
Bottom line: the Fed may not soon deliver craved for, demand rate cuts, but that doesn’t mean advisors lack for fixed income ideas that can deliver the goods for clients. FLTR proves as much.
Related: Vanguard Report Highlights Encouraging Retirement Savings Trends