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Using Floating Rate Notes for Rising Rates

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Using Floating Rate Notes for Rising Rates

The 10-year U.S. Treasury rate is reaching fresh highs, and the Federal Reserve has a more hawkish outlook than in recent years. In this environment, floating rate notes (FRNs) may be an effective investment grade alternative to other fixed income instruments. They offer a conservative, investment grade income allocation that can complement cash holdings with meaningful yield pickup, as well as a near-zero interest rate duration option within a fixed income portfolio.

Securities linked to Libor1 or interbank rates have benefited investors more recently as interest rates have climbed. Floating rate notes are securities that employ coupon reset mechanisms, which help limit interest rate duration by fluctuating in line with base interest rates. These securities have also helped increase income, particularly as Libor has risen over 100 basis points since last year, mainly influenced by U.S. monetary policy.

Investment Grade Floating Rate Notes

Floating rate notes offer a conservative, investment grade income allocation that can be a complement to cash holdings with meaningful yield pickup, as well as a near-zero interest rate duration option within a fixed income portfolio.

Furthermore, greater yield potential can be generated by selecting corporate floating rate notes. In addition, allocating to longer-maturity floating rate notes has, historically, increased yield potential with only incrementally higher average return volatility.

Related: Why Investors Should Focus on Real Yields

It is important to note that a weightings bias toward longer-maturity floating rate notes, as seen with the MVIS Investment Grade Floating Rate Note Index, has had a negligible impact on interest rate risk given the notes’ coupon reset mechanisms. The table below compares recent returns, yields, and durations of comparable investment grade indices, illustrating the attractive risk/return trade off of floating rate notes.

Limit duration risk and enhance short-term yield potential

Floating rate notes offer investment grade credit quality (i.e., BBB-rated and above), but with far less interest rate duration than traditional fixed income investments. Targeting corporate floating rate notes and longer average maturity notes may offer greater yield potential. Investors may use such an allocation to either enhance their cash positions or to meaningfully de-risk their portfolios from equity or below-investment grade credit exposures when market volatility becomes less favorable.

Investors can gain exposure to FRNs through VanEck Vectors® Investment Grade Floating Rate Note ETF (FLTR®).

IMPORTANT DISCLOSURE  
1London Interbank Offer Rate (Libor) refers to the benchmark used by banks, securities houses and investors to gauge the cost of unsecured borrowing in the money markets for various periods of time and currencies.
This content is published in the United States for residents of specified countries. Investors are subject to securities and tax regulations within their applicable jurisdictions that are not addressed on this content. Nothing in this content should be considered a solicitation to buy or an offer to sell shares of any investment in any jurisdiction where the offer or solicitation would be unlawful under the securities laws of such jurisdiction, nor is it intended as investment, tax, financial, or legal advice. Investors should seek such professional advice for their particular situation and jurisdiction.
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