Navigate ‟higher for longer” with floating rate bond ETFs

• Even with a rate cut cycle on the horizon, the bond market is pricing in the possibility that interest rates may stay “higher for longer.”¹
• Bond ETFs with floating interest rates can help investors seek capital preservation, boost current income, reduce interest rate risk, and diversify short-term bond holdings.
• Floating rate ETFs may offer exposure to U.S. government bonds, corporate bonds, securitized assets and bank loans.

Floating rate bonds are a type of fixed income security where the interest rate, or coupon, can go up or down depending on market conditions.

Floating rate bonds may help investors:

• Preserve capital: Treasury floating rate notes have traditionally served as a way to gain exposure to government bonds with minimal credit risk.
• Boost income: Interest rates on floating rate bonds currently vary from 5% to 8%, depending on the credit risk.² These bonds can pay a spread, or additional yield, above a short-term interest rate.
• Reduce interest rate risk: With durations currently close to zero, these bonds can be used to help reduce interest rate risk in a portfolio. Learn more about bond duration and why it’s so important to fixed income investors.
• Diversify short-term bond holdings: With over $6 trillion in money market funds,³ investors may seek to diversify the types of short-term bonds they hold ahead of expected Fed rate cuts later this year.

While traditional bonds typically pay a fixed rate throughout the life of the bond, interest rates on floating rate bonds can periodically reset based off a short-term interest rate, known as the “reference rate.”⁴

For many years, the most commonly used reference rate in finance was LIBOR, or the London Interbank Offered Rate. LIBOR was the rate an international bank would charge another bank for a short-term loan and was quoted over various time periods (overnight, 1-, 3-, 9-, and 12-months) and in various currencies. LIBOR was once tied to $200 trillion of financial instruments, including derivatives, bonds, mortgages and student loans.⁵

In May 2021, the Financial Conduct Authority (FCA) announced their intent to retire LIBOR benchmarks by June 30, 2023.⁶ Many U.S. dollar-based financial instruments and contracts have now transitioned to the Secured Overnight Financing Rate (SOFR), which is the new benchmark interest rate and has become the replacement for LIBOR.

SOFR is a measure of the cost of borrowing overnight funds, which are collateralized by U.S. Treasury securities.

The income paid by floating rate securities is the result of the floating rate plus a fixed spread. The fixed spread is determined at the time of issuance based on demand for the security and the market’s perception of the issuer’s credit risk. Historically, the higher the credit risk, the higher the fixed spread. The coupons typically reset quarterly and are paid quarterly or semi-annually.

Coupons reset quarterly to protect investors from interest rate fluctuations. The reset allows the coupon rate to adjust to the current market conditions, ensuring that the investment yields returns are in line with the prevailing interest rates. The quarterly reset is common because it strikes a balance between providing investors with some stability in their interest payments while still allowing for regular adjustments to reflect market changes.

^{Coupon = reference index (SOFR ) + fixed spread}

Today, investors have access to a broad spectrum of floating rate ETFs, including those that hold U.S. Treasury floating rate notes, investment grade corporate floating rate bonds, high yield floating rate bank loans, and AAA-rated collateralized loan obligations (CLOs). 

Currently, U.S. Treasury floating rate notes have a fixed spread of 0.11%. Meanwhile, investment grade floaters may have a spread of 0.41%, AAA-rated CLOs may have 1.25% and bank loans around 3.87% as of June 30, 2024. Figure 1 below provides a coupon breakdown for each of these instruments:

Figure 2: Types of floating rate instruments

Floating rate bonds may appeal to investors in elevated interest rate environments or when rates are increasing, which has largely been the case since the Federal Reserve’s first rate hikes in March of 2022. The first half of 2024 has seen a volatile interest rate environment, leading investors to continue looking at economic data for hints of what the Fed’s next move will be. The next rate cut cycle may not be as aggressive as previous cycles due to stubbornly high inflation.⁷ Investors may be able to take advantage of a “higher for longer” interest rate environment using a full suite of floating rate bond ETFs. Since the coupons reset frequently and there can be little duration risk, floating rate bond ETFs can help investors step out of cash while aiming to manage interest rate risk, potentially boost income and diversify short-term bond holdings.