In a fast changing environment, floating rate notes (FRNs) are an increasingly attractive asset class. They allow investors to hedge their portfolios, reduce the sensitivity to interest rate fluctuations and capture some potential yield, all while remaining in the investment grade universe. Investors also have the option of gaining exposure to FRNs via the ETF market.
As their name suggests, FRNs are bonds that do not have a fixed interest rate, but are pegged to a benchmark such as the US treasury bill rate or Libor, allowing their coupon to be rebalanced at regular intervals. Therefore unlike other bonds, FRNs are unlikely to lose capital value as rates rise. FRNs are very well suited to today’s economic landscape.
During the first 10 months of 2016, 10-year yields were falling across all G10 countries (Germany, the United States, Japan, the United Kingdom, Canada, Australia, New Zealand, Norway, Sweden and Switzerland). By the end of Q3 2016, yield curves in Germany and the United Kingdom were at their flattest since 2008, and in the US at their flattest since 2007. This can mostly be explained by the attitude of central banks; except for the US Fed and the Bank of Canada, all other G10 countries eased their monetary policies, either by lowering interest rates or expanding their balance sheets. Historically, this kind of shift is observed at the end of the economic cycle, when unemployment is close to its cyclical low.
Donald Trump’s election victory broke the dynamic observed in fixed income markets. After these elections, long-term yields have risen dramatically, largely as long-term inflation expectations have risen, while the latter were historically low.
While US rates have started rising in the wake of Donald Trump’s election, global bond yields remain fairly low. From this perspective, the Markit iBoxx USD Liquid FRN Investment Grade Corporates 100 index (which provides an exposure to the most liquid US floating rate notes) can be a fitting option: with almost zero sensitivity to interest rates, it has risen by 1.2 per cent since the election of Donald Trump, while a fixed rate corporate index with equivalent maturity has risen by a little over 0.31 per cent. At the end of February 2017, it boasted a USD net yield of 2.52 per cent.
Exposure to this index via an ETF is an interesting solution for investors. While FRNs are USD denominated giving exposure to exchange rates, an FRN ETF may also include EUR/USD hedging. As the US dollar has appreciated by 23.06 per cent versus the euro over the last three years, this hedging would help minimise the exchange rate impact in case of trend reversal.
At the end of February 2017, one example of an FRN ETF provided a 0.81 per cent net yield for a 3.23-year maturity. With identical maturity and rating, European credit provides a 0.15 per cent return, and can only reach the 0.81 per cent threshold after a seven-year maturity period, which increases sensitivity and, consequently, risk.
Like other fixed income products, FRNs are more complicated to trade than equities. ETFs allow exposure to a basket of FRNs in only one transaction. This kind of product has been available to European investors since 2015, while it first appeared on the US market in 2011.
In the past 12 months, these ETFs have seen inflows of €2.9bn. This implies a strong appetite among investors to gain exposure to FRNs as a way of reducing risk in today’s rate environment.
Nicolas Fragneau is head of Amundi ETF Product Specialists