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December 20, 2018An Investment Grade Solution for Rising Rates (09:15)
Fran Rodilosso
Fran Rodilosso
Head of Fixed Income ETF Portfolio Management, CFA
In an investment portfolio, FRNs (Floating Rate Notes) can provide good protection against rising interest rates.

An Investment Grade Solution for Rising Rates

WILLIAM SOKOL: U.S. interest rates have continued their steady climb upwards this year, reflecting, among other things, momentum in economic growth. With rates moving up, investors are seeking out ways to reduce their interest rate exposure, as evidenced by substantial inflows into ultra-short duration strategies including floating rate notes.

I'm Bill Sokol, Director of ETF Product Management at VanEck. And here to talk more about floating rate note strategies is Fran Rodilosso, head of our fixed income ETF portfolio management team. Fran, thanks for being here.

FRANCIS RODILOSSO: Thank you, Bill. Thanks for having me.

SOKOL: Fran, given that rates have already moved up quite a bit this year with LIBOR (London Interbank Offered Rate) now at its highest level in a decade, why consider floating rate notes right now?

RODILOSSO: It's really a good question, Bill. Rates are higher than they have been over the last 10 years, but largely because we were in such a period of unprecedented low rates – unprecedented easy monetary policy on a global basis. Many consider us to be still in the early stages, particularly when you look at it globally, not just what the U.S. Federal Reserve (Fed) is doing, but the Bank of Japan, and very eventually, the European Central Bank. Anyway, we're in potentially a prolonged period where rates could be rising or normalizing even.

We're certainly not, from a historical point of view, at a very high level of rates. So, leaving all that aside, rates are still expected to rise regardless. The Fed is showing plans. One more hike this year. Most of the market seems to be fixed around three or four next year. So, the reason number one is rates are still expected to continue to rise. The global growth scenario, the U.S. growth scenario in particular, tends to support further movements toward higher rates. So FRNs (Floating Rate Notes), whose coupons reset quarterly with LIBOR have a duration of 0.12 – virtually zero duration – are still a good response, good protection in your portfolio against those rising rates. And as the underlying assets in an FRN portfolio are investment grade, there's a margin of credit safety. People are concerned about investment grade credit or where we are in the credit cycle in general. But still, investment grade is where people go for more safety versus the high yield portion of the market at this point in time. Yields are currently attractive on FRNs. They do provide a spread over LIBOR, or at least the corporate FRNs do. So, our ETF that we manage, FLTR®, the VanEck Vectors® Investment Grade Floating Rate ETF, does provide a fairly attractive spread in my mind over LIBOR at this point in time, between 70 and 75 basis points.

SOKOL: Could you give us some more background on the market? How big is it and who's issuing?

RODILOSSO: Sure. Well, FLTR's index for instance, has a market cap of approximately U.S. $330 billion. There are over 300 issuers in that index. This is all investment grade, a very important concept to talk about when you think about floating rate because one of the most popular investment vehicles in recent times has been bank loans or levered loans. And that is the loan market for sub-investment grade issuers.

FRNs trade more like bonds – normal T+2 settlement cycle. And they are issued by investment grade borrowers. One of the main differences from the fixed rate market is the types of issuers though. FRNs tend to be issued by financial companies, mainly banks. So, the index that FLTR tracks is over 70% banks. So the plus side of that is if you have a favorable outlook on banks right now with rates rising, banks have actually been doing fairly well, this might be attractive.

They’re also a bit of a diversifier, you have lower exposure to some of the, call it less desirable, or at least the sectors that the market's been more concerned about lately, such as telecom, retail, and, more recently, energy and mining and sectors like that.

SOKOL: You mentioned bank loans, which is another floating rate asset class. There are other low-duration strategies that investors can allocate to, to reduce interest rate risk. Why consider floating rate notes over these other options?

RODILOSSO: Another really good question. You figure to reduce duration in your portfolio, you can either hold cash, or short-term bonds – very short term bonds – or, as we were talking about just a minute ago, you could hold something like levered loans, or bank loan funds. Versus cash, FRNs do provide a healthy yield advantage: I mentioned earlier, currently, FLTR, for instance, 70-75 basis points above LIBOR, which is not insignificant particularly when you look at your money market options. Which are below LIBOR. Short-term fixed rate bonds are an option, with, right now, a small yield pick-up over, say, FRNs. But they still do have duration. Most of those types of products or funds are in a zero to 5-year category. An average duration is closer to 2.5, I believe, in those products.

So you do still have a level of interest rate risk, longer spread risk actually. A little higher sensitivity also to movements in credit spreads in those fixed rate funds versus FRNs. So for marginal yield pickups. So the question is the risk-reward there. You're better off just getting the near zero interest rate duration. Then as I mentioned, bank loans. That's just a question of a credit exposure decision. That's one reason why people may favor investment grade FRNs rather than going farther out the credit curve for definitely a yield pickup. But also, aside from it, the sort of credit aspect, there is the structural aspect. And for many investors, bank loans are attractive. Historically, they've held up well in terms of default rates and recovery rates, but they're still sub-investment grade and they're still loans, particularly in, say, ETF structures having instruments that have longer than the normal T+2 settlement cycle.

They settle by assignment, usually at least a seven day period. That's one of the areas where if the market does grow concerned about the ETF structure, and how it holds up, the vast majority of ETFs have certainly shown to be able to withstand all types of market situations. But there is a settlement/structural mismatch there. Those funds have managed well through periods of volatility to date. So there's a credit question and a structural question on the bank loan side versus FRNs.

SOKOL: Lastly, how can investors use FLTR in their portfolio?

RODILOSSO: Well, it is a way of reducing overall duration in your portfolio for sure. I would consider it not a clean substitute for cash, but a riskier alternative to cash that still is at the safer end of the corporate bonds universe. So, for investors who are thinking, "Okay, I still need some yield. I want to reduce duration,” FLTR is a fairly good alternative. If they want to make some riskier bets on certain asset classes, emerging markets debt, for instance, even local currency, or they do like some parts of the high yield market but want to move down the risk curve in other parts – sort of the risk barbell approach – FLTR is to me a fairly good option.

SOKOL: Thanks, Fran, for sharing your perspective.

RODILOSSO: Thank you, Bill. Thanks again.

SOKOL: And if you'd like to learn more about FLTR or subscribe to receive additional insights from Fran and other VanEck thought leaders, please visit our website at

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