We have come a long way from the “zero interest rate policy” implemented by the U.S. Federal Reserve in the aftermath of the financial crisis. Today, the Fed Funds target rate, the rate it pays banks on excess reserves, is in the range of 1.75–2.00%. The Fed is widely expected to raise rates at least one more time this year following a 0.25% hike on June 13; that would put the target in the range of 2.00%-2.25%, a level not seen since 2008. (Source: FRED/St. Louis Federal Reserve.)
One of the ways that investors can help navigate a rising rate environment is through exposure to bonds with coupons that adjust, or float, with short-term interest rates. These adjustments mean investors are not exposed to potential price losses, and can also benefit from income increases as rates rise over time.
Understanding floating rate notes
While there are several types of debt instruments with variable interest rates, such as bank loans or variable rate demand notes (VRDNs), floating rate notes (FRNs) are growing more popular with investors. These investment-grade bonds, issued primarily by corporations, have coupons that periodically reset using a short-term interest rate and typically have maturity dates ranging from 18 months to five years. Most floating rate notes pay coupons quarterly, but a few pay monthly.
How are coupons reset?
FRN coupons are adjusted on periodic reset dates, typically three months after the bond was issued. The coupons are calculated based on the following formula:
Coupon = Reference Index Rate + Fixed Spread
The reference index is a short-term interest rate, typically the 1-month or 3-month London Interbank Offer Rate (LIBOR). LIBOR is the rate an international bank would charge another bank for a short-term loan, so it tends to be higher than the Fed Funds target rate.
The fixed spread is determined at the time of issuance, and is based on the market’s perception of the issuer’s credit risk. The fixed spread does not change over the life of the bond. Here’s an illustration of how resets might work.
Floating rate notes versus bank loans
Investors might be familiar with bank loans or leveraged loans, which are high-yield loans that also have coupons that reset with 3-month LIBOR. The popularity of these instruments has grown over the past decade, as investors sought higher yields when rates were exceedingly low. While FRNs and bank loans both offer floating interest rates, they have key differences in terms of credit quality and liquidity.
For illustrative purposes only. This illustration does not represent the actual performance of any iShares Fund.
Floating rate notes in a portfolio
Investors can use FRNs to help manage risk and return in a rising rate environment, by making adjustments to their portfolios:
- Put cash to work - Investors who use cash equivalents in an effort to protect portfolios from rising rates run the risk that their income might not keep pace with inflation. Floating rate notes may offer more income to help maintain purchasing power, although it’s important to note they don’t have protection of principal as a bank deposit or money market fund would.
- Reduce portfolio duration - The duration, or interest rate sensitivity, of floating rate notes tends to be very short, as the bond’s coupon regularly resets. The Bloomberg Barclays Floating Rate Note <5 Years Index had a duration of 0.15 years as of May 31, 2018, meaning it carries very little exposure to interest rate risk. By comparison, core bond indexes like the Bloomberg Barclays U.S. Aggregate Index had a duration of 5.95 years. (Durations are from Bloomberg.)
- Gain exposure to short-duration credit - FRNs offer access to corporate debt, which may generate more income than a similar maturity U.S. government bond. However, U.S. government bonds are generally considered to have less credit risk.
Exchange traded funds, such as iShares Floating Rate Bond ETF (FLOT), are a convenient, low-cost way to add diversified exposure to a bond portfolio, while managing interest rate risk in a rising rate environment.
Build on Insight, by BlackRock, written by Karen Schenone, CFA Fixed Income Product Strategist
Carefully consider the Funds’ investment objectives, risk factors, and charges and expenses before investing. This and other information can be found in the Funds’ prospectuses or, if available, the summary prospectuses which may be obtained by visiting www.blackrock.com/latamiberia. Read the prospectus carefully before investing.
Investing involves risk, including possible loss of principal.
Fixed income risks include interest-rate and credit risk. Typically, when interest rates rise, there is a corresponding decline in bond values. Credit risk refers to the possibility that the bond issuer will not be able to make principal and interest payments.
Securities with floating or variable interest rates may decline in value if their coupon rates do not keep pace with comparable market interest rates. The Fund’s income may decline when interest rates fall because most of the debt instruments held by the Fund will have floating or variable rates.
When comparing stocks or bonds and iShares Funds, it should be remembered that management fees associated with fund investments, like iShares Funds, are not borne by investors in individual stocks or bonds. Buying and selling shares of iShares Funds will result in brokerage commissions.
Diversification and asset allocation may not protect against market risk or loss of principal.
There can be no assurance that an active trading market for shares of an ETF will develop or be maintained.
Transactions in shares of ETFs will result in brokerage commissions and will generate tax consequences. All regulated investment companies are obliged to distribute portfolio gains to shareholders.
An investment in fixed income funds is not equivalent to and involves risks not associated with an investment in cash. The Funds are distributed by BlackRock Investments, LLC (together with its affiliates, “BlackRock”).
The iShares Funds are not sponsored, endorsed, issued, sold or promoted by Barclays or Bloomberg Finance L.P., nor do these companies make any representation regarding the advisability of investing in the Funds. BlackRock is not affiliated with the companies listed above.
This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of June 2018 and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader.
In Latin America and Iberia, for institutional investors and financial intermediaries only (not for public distribution). This material is for educational purposes only and does not constitute investment advice or an offer or solicitation to sell or a solicitation of an offer to buy any shares of any fund or security and it is your responsibility to inform yourself of, and to observe, all applicable laws and regulations of your relevant jurisdiction. If any funds are mentioned or inferred in this material, such funds may not been registered with the securities regulators of Argentina, Brazil, Chile, Colombia, Mexico, Panama, Peru, Portugal, Spain Uruguay or any other securities regulator in any Latin American or Iberian country and thus, may not be publicly offered in any such countries. The securities regulators of any country within Latin America or Iberia have not confirmed the accuracy of any information contained herein. No information discussed herein can be provided to the general public in Latin America or Iberia. The contents of this material are strictly confidential and must not be passed to any third party.
©2018 BlackRock. iSHARES and BLACKROCK are registered trademarks of BlackRock. All other marks are the property of their respective owners.
Karen Schenone is a Fixed Income Product Strategist within BlackRock’s Global Fixed Income Group focusing on iShares fixed income ETFs. She concentrates on supporting iShares clients, generating content on fixed income markets and ETFs, developing new fixed income iShares ETF strategies, and partnering with the iShares team on product delivery. She writes about fixed income ETFs and trends in that sector.