Combat Rising Interest Rates With This Low-Credit-Risk ETF

IShares Floating Rate Bond ETF

FLOT is a solid option for investors worried about rising interest rates and credit risk. This low-fee fund invests in investment-grade corporate bonds whose interest payments grow as rates rise. It was recently upgraded to a Morningstar Analyst Rating of Bronze from Neutral based on a reassessment of its fee relative to its competitors.

The fund tracks the Bloomberg Barclays U.S. Floating Rate Note < 5 Years Index, which offers market-cap-weighted exposure to investment-grade, variable interest-rate bonds with less than five years until maturity. These bonds tie their coupon payments to the three-month London Interbank Offer Rate. So, when rates rise, they offer higher coupon payments and their prices don’t fall as much as fixed-rate bonds. In contrast, most funds in the ultrashort-bond Morningstar Category invest in fixed-rate corporate and government bonds with less than three years remaining until maturity. The fund effectively protects against rising rates, but it does take moderate credit risk and loses out when rates fall.

More than half of the portfolio is dedicated to the financials sector, which is a source of risk. The fund’s financial-services sector exposure was less than a fourth of the portfolio five years ago according to Morningstar data. This concentration is mostly driven by large U.S. banks. Since 2010, these firms issued a record amount of debt to take advantage of low rates and meet the strict postcrisis capital requirements.

BlackRock, which manages this fund, has produced a decent index-tracking record. From its June 2011 inception through May 2018, this fund annually trailed its index by 0.20%, in line with its 0.20% fee. The fund’s corporate holdings helped it outpace the category average, where cash and equivalents make up one third of the typical portfolio. The strategy’s five-year annual return through May 2018 of 1.0% bested the category mean by 0.20%. Its risk-adjusted return, measured by Sharpe ratio, also beat the category group over the same period.

Fundamental View Floating-rate bonds are debt obligations with variable interest payments. Their coupons typically adjust every three-month to reflect changes in Libor. These floating instruments tend to perform well in a rising-interest-rate environment. In this environment, the fund's coupons are adjusted upward, while the value of the fixed-rate bond funds tend to decline. On the other hand, when interest-rates fall, the price of the fixed-rate bonds gain and floating rate bonds' coupons are adjusted downward. Even though both groups have a short duration, they behave differently.

For a low fee, this indexed portfolio replicates the composition of the investment-grade floating-rate bond market and reflects collective views of market participants about the value of each security. But there are some drawbacks.

Market-cap weighting skews the portfolio toward the largest debt issuers. In the floating-rate investment-grade corporate fixed-income market, there have been record debt issuances by U.S. financial institutions in recent years. The issuances were largely driven by low rates and postcrisis regulatory changes.

The portfolio is biased toward the financial-services sector, which accounted for more than half of the portfolio as of June 2, 2018. U.S. bank issuers make up six out of the fund’s 10 largest positions. This concentration makes the fund highly vulnerable to sector-specific risk. Its category peers typically allocate less than 20% of their portfolios to the financials sector.

Additionally, the fund is concentrated on the lower end of the investment-grade spectrum, with considerable exposure to bonds rated A and BBB. These securities, which are mostly banking-sector bonds, take up more than 60% of the portfolio. On average, the fund’s peers invest roughly one third of their assets in A or BBB rated bonds. While these bonds are on the lower end of the investment-grade credit quality spectrum, they have relatively low default risk and offer a higher yield than Treasury securities with comparable terms. The balance of assets is in higher-rated AAA and AA securities.

This fund has efficiently tracked its index since its June 2011 inception. From inception through May 2018, it gained 1.1% annually, while the index returned 1.3%. The fund’s five-year annualized return through May 2018 of 1.1% was better than 80% of its peers. This outperformance principally stems from its relatively aggressive credit profile. The fund, however, is likely to lag its peers during market downturns when credit spreads widen.

Portfolio Construction The fund earns a Positive Process rating because it accurately represents its target universe and transparently weights its holdings through a market-cap-weighted approach, which mitigates transaction costs. The underlying universe is sensibly constructed, but it is not well-diversified across sectors.

This portfolio tracks the Bloomberg Barclays U.S. Floating Rate Note < 5 Years Index. The index reflects the performance of U.S.-dollar-denominated, investment-grade floating-rate notes. Securities in the index have at least one month and less than five years remaining until maturity, and at least $300 million in outstanding face value. Their interest payments are based on three-month Libor, with a fixed spread. Components of the index primarily include securities of financials and industrials companies and government-related securities. The fund may invest in non-U.S. corporate, government, and supranational entity bonds from several other countries. The index is market-cap-weighted and updated on the last calendar day of each month.

Fees Although there are lower-cost options in the category, the fund's 0.20% fee is still competitive against floating-rate mandate strategies that charge 0.50% on average and is lower than the ultrashort-bond category average of 0.40%. The portfolio receives a Positive Price Pillar rating.

Alternatives

Bronze-rated

As of this writing,

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