Rising interest rates have made the bond market a volatile place to invest, and for some investors, a floating rate note ETF can provide a valuable hedge against interest rate and inflation risks.
“This whole idea that fixed income is safe and it can’t go down isn’t necessarily true, and we’ve seen that this year,” said Jeff Carter, Portfolio Manager and Chief Compliance Officer with fixed income manager Canso Investment Counsel Ltd.
“Depending on what your duration is, your fixed income can go down significantly. I think it’s probably caused a lot of investors and advisors to think about where they are on the curve and where we are in the interest rate cycle, but that’s also the attraction of a floating rate product.”
Floating rate notes (FRNs) are debt instruments with a variable interest rate, unlike the fixed rate for traditional bonds. The FRN interest rate is tied to a benchmark rate, such as the Canadian Dealer Offered Rate (CDOR), the Federal Reserve’s Federal Funds Rate, the London Interbank Offered Rate (LIBOR), or the national prime rate. They can be issued by financial institutions, governments and their agencies or corporations, and typically have maturities between two and five years.
“The most important function of a floating rate note is the floating rate coupon, which unlike other fixed income securities, is not fixed at issuance,” said Ian Marthinsen, Portfolio Strategist with Lysander Funds Ltd., an investment fund manager who partners with portfolio managers to offer investment solutions that help investors reach their financial goals.
“Their coupons will change based on a reference interest rate. As interest rates rise, so does the coupon stream of a floating rate note, and so does the income that an investor receives.”
That provides a level of protection from rising rates, since for traditional bonds, there is an inverse relationship between their prices and interest rates – which means that when rates rise, bond prices fall. And while floaters usually pay a lower yield to investors than comparable fixed coupon bonds at issuance, they do so in exchange for the additional security of having an investment that will pay more coupon interest as the benchmark rate rises.
“In periods when you think there might be inflation, it’s not a bad idea to have an allocation in a floating rate product,” says Carter.
“If there’s inflation and central banks react and raise overnight rates, the floating rate benchmarks – CDOR, CORRA, SOFR, LIBOR – will react accordingly and move higher and your interest income increases. It’s a nice hedge that way.”
Many advisors and investors are more comfortable holding securities within an ETF, since it’s something they’re more familiar with. And given that ETFs have a market maker (or a designated broker who is providing liquidity by trading the designated vehicles throughout the day), they feel they have more control over what they’re buying compared to a mutual fund, where all purchases can only happen at the end of day. ETFs and mutual funds enable retail investors to access FRNs, since these aren’t the type of security they could simply buy on an exchange themselves.
But the ETF is only the packaging – like any investment, it’s important for advisors and investors alike to understand what comprises the fund, so they’re clear on what assets they’re indirectly holding.
John Laing, Portfolio Manager with Canso, which is launching its first FRN ETF with Lysander, says the fund will hold primarily investment grade FRNs with the capacity to access the high yield market, if and when they see fit.
“When people talk about floating rate securities, they bunch together high yield or leveraged loans as well as high grade floating rate notes, but they’re very different; very much like an investment grade bond and a high yield bond are very different,” Laing says.
“There are times when high yield and leveraged loans are attractive, and there are times when it’s a space you don’t want to be involved in. We don’t like to be a straight high-yield manager; we don’t think that’s a good way to be a custodian of other people’s money. We always manage our mandates to allow flexibility.”
As with any investment, he adds, “it’s important to know what makes up that fund, what the holdings are and what the constraints or restrictions on the actual fund are.”
“You can have a lot of titles out there and the name of the fund or ETF doesn’t necessarily tell you exactly what its capabilities are.”
Against the current backdrop of high inflation and rising interest rates, FRNs could help provide investors with the capital preservation characteristics they expect from bonds in uncertain economic times.
According to Marthinsen, “If you go long duration with traditional bonds, rising interest rates work against you and can lead to investment losses; whereas with investment grade FRNs, you benefit from those same rising interest rates to earn more interest income.”
The views and information expressed in this publication are for informational purposes only. Information in this publication is not intended to constitute legal, tax, securities or investment advice and is made available on an “as is” basis. Information in this presentation is subject to change without notice. Neither Lysander Funds Limited nor Canso Investment Counsel Ltd. assume any duty to update any information herein. Certain information in this publication has been derived or obtained from sources believed to be trustworthy and/or reliable. Neither Lysander Funds Limited nor Canso Investment Counsel Ltd. assume responsibility for the accuracy, currency, reliability or correctness of any such information.