Higher Yield and Diversification with Floating Rate Opportunities
July 10, 2024
Read Time 3 MIN
With the Fed on hold and rates expected to remain higher for longer, floating rate instruments offer a way to generate higher yields while also providing diversification benefits within a core income portfolio. In our view, these are three compelling ways to gain exposure to floating rate instruments:
- Collateralized loan obligations (CLOs) can offer investors high yield potential with built-in risk protection
- Corporate floating rate notes (FRNs) can be attractive as a high quality cash complement
- Access the benefits of private credit through a liquid and diversified exposure such as business development companies (BDCs)
In a recent webinar, VanEck’s Bill Sokol and Coulter Regal discussed the outlook for these areas of the floating rate market with Fran Rodilosso, Portfolio Manager, Head of Fixed Income ETFs. See below for key highlights from the discussion.
Current Environment and Outlook
- CLO spreads have rallied strongly, yields remain high. CLO spreads were above historical averages until recently. Overall yields remain significantly higher than historical averages, a reflection of the current environment of high short-term rates. (8:16)
- Loan fundamentals remain strong. Leverage in the loan market is at four-year lows, and although average interest coverage has recently declined, it remains at very high levels relative to history. This fundamental backdrop suggests that issuing companies are in a position of relative strength. (10:51)
- Defaults are increasing but remain subdued. In both the high yield bond and loan markets, there has not been a large increase in defaults—historically, defaults peak 1-2 years after the Fed stops hiking interest rates. (13:05)
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Collateralized Loan Obligations: Engineered for Income with Built-in Risk Protection (14:52)
- A CLO is a portfolio of predominantly senior secured bank loans (aka leveraged loans) that is securitized and actively managed. CLOs are not just a hedge against rising rates. They also have historically provided higher levels of income for a lower level of risk – making a clear case for a strategic allocation.
- CLOs are structured to help mitigate risk through the strength of their underlying collateral as well as built-in traits such as subordination, active management and the cashflow waterfall that is designed to ensure senior debt investors get paid first. This has historically helped them experience significantly lower default rates compared to corporate debt and other securitized products.
- High yields and very low default rates have resulted in a track record of strong risk-adjusted returns versus other fixed income asset classes, particularly among investment grade rated CLO tranches.
CLOI | VanEck CLO ETF
Enhanced Yield Floating Rate Notes (FRNs) (41:27)
- FRNs have coupons that are based on a short-term base rate such as the Secured Overnight Funding Rate (SOFR), which reflects short-term funding costs, and an additional fixed spread that reflects the credit risk of the issuer.
- In the current “higher for longer” environment, investment grade corporate floating rate notes may continue to offer an attractive combination of enhanced yields and safety. The floating rate nature of FRNs means they have low or negative correlation to rate-sensitive fixed income asset classes, such as Treasuries or fixed coupon investment grade bonds. This may allow FRNs to fulfill two primary roles that fixed income can have within a balanced portfolio: income and diversification.
- Further, this is achieved without adding significant credit risk since the bonds carry investment grade ratings. This contrasts with leveraged loans, which provide higher yields but much higher credit risk.
FLTR | VanEck IG Floating Rate ETF
Business Development Companies (BDCs): Access the Income Potential of Private Credit (45:43)
- BDCs are a compelling option for investors seeking exposure to the potential benefits of private credit without sacrificing the ability to access their capital when necessary.
- BDCs generate income by lending to, and investing in, middle market companies in a variety of ways including equity, debt and hybrid financial instruments.
- BDCs offer the same benefits as traditional private credit strategies – the potential for higher yields and diversification away from traditional stocks and bonds – but in a much more liquid form.
BIZD | VanEck BDC Income ETF
Listen to a full replay of the discussion below.
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IMPORTANT DISCLOSURES
This is not an offer to buy or sell, or a recommendation to buy or sell any of the securities, financial instruments or digital assets mentioned herein. The information presented does not involve the rendering of personalized investment, financial, legal, tax advice, or any call to action. Certain statements contained herein may constitute projections, forecasts and other forward-looking statements, which do not reflect actual results, are for illustrative purposes only, are valid as of the date of this communication, and are subject to change without notice. Actual future performance of any assets or industries mentioned are unknown. Information provided by third party sources are believed to be reliable and have not been independently verified for accuracy or completeness and cannot be guaranteed. VanEck does not guarantee the accuracy of third party data. The information herein represents the opinion of the author(s), but not necessarily those of VanEck or its other employees.
There are inherent risks with fixed income investing. These risks may include interest rate, call, credit, market, inflation, government policy, liquidity, or junk bond. When interest rates rise, bond prices fall. This risk is heightened with investments in longer duration fixed-income securities and during periods when prevailing interest rates are low or negative.
An investment in the VanEck CLO ETF (CLOI) may be subject to risks which include, but are not limited to, risks related to Collateralized Loan Obligations (CLO), debt securities, foreign currency, foreign securities, investment focus, newly-issued securities, extended settlement, affiliated fund investment, management and capital preservation, derivatives, currency management strategies, cash transactions, market, Sub-Adviser, operational, authorized participant concentration, no guarantee of active trading market, trading issues, fund shares trading, premium/discount, liquidity of fund shares, non-diversified, and seed investor risks, all of which may adversely affect the Fund. Investments in debt securities may expose the Fund to other risks, such as risks related to liquidity, interest rate, floating rate obligations, credit, call, extension, high yield securities, income, valuation, privately-issued securities, covenant lite loans, default of the underlying asset and CLO manager risks, all of which may impact the Fund’s performance. Derivatives may involve certain costs and risks such as liquidity, interest rate, and the risk that a position could not be closed when most advantageous.
An investment in the VanEck IG Floating Rate ETF (FLTR) may be subject to risks which includes, among others, foreign securities, foreign currency, credit, interest rate, floating rate, floating rate LIBOR, restricted securities, financials sector, market, operational, sampling, index tracking, authorized participant concentration, no guarantee of active trading market, trading issues, passive management, fund shares trading, premium/discount and liquidity of fund shares, non-diversified, and index-related concentration risks, all of which may adversely affect the Fund.
VanEck BDC Income ETF: Business Development Companies (BDCs) generally invest in less mature U.S. private companies or thinly traded U.S. public companies which involve greater risk than well-established publicly-traded companies. While the BDCs that comprise the Index are expected to generate income in the form of dividends, certain BDCs during certain periods of time may not generate such income. The Fund will indirectly bear its proportionate share of any management fees and other operating expenses incurred by the BDCs and of any performance-based or incentive fees payable by the BDCs in which it invests, in addition to the expenses paid by the Fund. A BDC’s incentive fee may be very high, vary from year to year and be payable even if the value of the BDC’s portfolio declines in a given time period. Incentive fees may create an incentive for a BDC’s manager to make investments that are risky or more speculative than would be the case in the absence of such compensation arrangements, and may also encourage the BDC’s manager to use leverage to increase the return on the BDC’s investments. The use of leverage by BDCs magnifies gains and losses on amounts invested and increases the risks associated with investing in BDCs. A BDC may make investments with a larger amount of risk of volatility and loss of principal than other investment options and may also be highly speculative and aggressive. The Fund and its affiliates may not own in excess of 25% of a BDC's outstanding voting securities which may limit the Fund's ability to fully replicate its index. An investment in the Fund may be subject to risks which include, among others, investing in BDCs, investment restrictions, financial sector, small- and medium-capitalization companies, equity securities, derivatives, derivatives counterparty, liquidity risk related to swap agreements, floating rate risk for BDCs, floating rate LIBOR, market, operational, regulatory, index tracking, authorized participant concentration, no guarantee of active trading market, trading issues, passive management, fund shares trading, premium/discount and liquidity of fund shares, issuer-specific changes, and index-related concentration risks, all of which may adversely affect the fund. Small- and medium-capitalization companies may be subject to elevated risks.
Investing involves substantial risk and high volatility, including possible loss of principal. An investor should consider the investment objective, risks, charges and expenses of a Fund carefully before investing. To obtain a prospectus and summary prospectus, which contain this and other information, call 800.826.2333 or visit vaneck.com. Please read the prospectus and summary prospectus carefully before investing.
© Van Eck Securities Corporation, Distributor, a wholly-owned subsidiary of Van Eck Associates Corporation.
Related Funds
IMPORTANT DISCLOSURES
This is not an offer to buy or sell, or a recommendation to buy or sell any of the securities, financial instruments or digital assets mentioned herein. The information presented does not involve the rendering of personalized investment, financial, legal, tax advice, or any call to action. Certain statements contained herein may constitute projections, forecasts and other forward-looking statements, which do not reflect actual results, are for illustrative purposes only, are valid as of the date of this communication, and are subject to change without notice. Actual future performance of any assets or industries mentioned are unknown. Information provided by third party sources are believed to be reliable and have not been independently verified for accuracy or completeness and cannot be guaranteed. VanEck does not guarantee the accuracy of third party data. The information herein represents the opinion of the author(s), but not necessarily those of VanEck or its other employees.
There are inherent risks with fixed income investing. These risks may include interest rate, call, credit, market, inflation, government policy, liquidity, or junk bond. When interest rates rise, bond prices fall. This risk is heightened with investments in longer duration fixed-income securities and during periods when prevailing interest rates are low or negative.
An investment in the VanEck CLO ETF (CLOI) may be subject to risks which include, but are not limited to, risks related to Collateralized Loan Obligations (CLO), debt securities, foreign currency, foreign securities, investment focus, newly-issued securities, extended settlement, affiliated fund investment, management and capital preservation, derivatives, currency management strategies, cash transactions, market, Sub-Adviser, operational, authorized participant concentration, no guarantee of active trading market, trading issues, fund shares trading, premium/discount, liquidity of fund shares, non-diversified, and seed investor risks, all of which may adversely affect the Fund. Investments in debt securities may expose the Fund to other risks, such as risks related to liquidity, interest rate, floating rate obligations, credit, call, extension, high yield securities, income, valuation, privately-issued securities, covenant lite loans, default of the underlying asset and CLO manager risks, all of which may impact the Fund’s performance. Derivatives may involve certain costs and risks such as liquidity, interest rate, and the risk that a position could not be closed when most advantageous.
An investment in the VanEck IG Floating Rate ETF (FLTR) may be subject to risks which includes, among others, foreign securities, foreign currency, credit, interest rate, floating rate, floating rate LIBOR, restricted securities, financials sector, market, operational, sampling, index tracking, authorized participant concentration, no guarantee of active trading market, trading issues, passive management, fund shares trading, premium/discount and liquidity of fund shares, non-diversified, and index-related concentration risks, all of which may adversely affect the Fund.
VanEck BDC Income ETF: Business Development Companies (BDCs) generally invest in less mature U.S. private companies or thinly traded U.S. public companies which involve greater risk than well-established publicly-traded companies. While the BDCs that comprise the Index are expected to generate income in the form of dividends, certain BDCs during certain periods of time may not generate such income. The Fund will indirectly bear its proportionate share of any management fees and other operating expenses incurred by the BDCs and of any performance-based or incentive fees payable by the BDCs in which it invests, in addition to the expenses paid by the Fund. A BDC’s incentive fee may be very high, vary from year to year and be payable even if the value of the BDC’s portfolio declines in a given time period. Incentive fees may create an incentive for a BDC’s manager to make investments that are risky or more speculative than would be the case in the absence of such compensation arrangements, and may also encourage the BDC’s manager to use leverage to increase the return on the BDC’s investments. The use of leverage by BDCs magnifies gains and losses on amounts invested and increases the risks associated with investing in BDCs. A BDC may make investments with a larger amount of risk of volatility and loss of principal than other investment options and may also be highly speculative and aggressive. The Fund and its affiliates may not own in excess of 25% of a BDC's outstanding voting securities which may limit the Fund's ability to fully replicate its index. An investment in the Fund may be subject to risks which include, among others, investing in BDCs, investment restrictions, financial sector, small- and medium-capitalization companies, equity securities, derivatives, derivatives counterparty, liquidity risk related to swap agreements, floating rate risk for BDCs, floating rate LIBOR, market, operational, regulatory, index tracking, authorized participant concentration, no guarantee of active trading market, trading issues, passive management, fund shares trading, premium/discount and liquidity of fund shares, issuer-specific changes, and index-related concentration risks, all of which may adversely affect the fund. Small- and medium-capitalization companies may be subject to elevated risks.
Investing involves substantial risk and high volatility, including possible loss of principal. An investor should consider the investment objective, risks, charges and expenses of a Fund carefully before investing. To obtain a prospectus and summary prospectus, which contain this and other information, call 800.826.2333 or visit vaneck.com. Please read the prospectus and summary prospectus carefully before investing.
© Van Eck Securities Corporation, Distributor, a wholly-owned subsidiary of Van Eck Associates Corporation.