In an attempt at stemming hotter-than-expected inflation, the Federal Reserve (Fed) raised its target interest rate by 0.75% last week,1 its biggest increase since 1994. Investors in turn braced themselves for an increasingly hawkish Fed, and the S&P 500® Index closed the week down -5.8%2 — the most since March 2020. The Fed also began its quantitative tightening program, unwinding its balance sheet at a faster pace than the previous unwind in 2017.
Floating-Rate Notes in a Rising Rate Environment
The Fed hinted that a similarly aggressive hike may come at their next meeting in July, as they seek to tame the highest inflation in 40 years.3 Investors looking for lower rate-risk options may want to consider floating-rate notes.
Because they adjust to movements in short-term rates, floating-rate notes are low-duration (0.06 years), income-producing (2% yield-to-worst) instruments. Relative to fixed-rate bonds, floating-rate notes offer improved potential to mitigate duration-induced headwinds during periods of rising rates.4
Source: Bloomberg Finance L.P., December 31, 2002 – May 31, 2022. Past performance is not a reliable indicator of future performance. Index returns are unmanaged and do not reflect the deduction of any fees or expenses. Index returns reflect all items of income, gain and loss and the reinvestment of dividends and other income as applicable.
Diversification Potential of Floating-Rate Notes
In addition to their lower rate risk, floating-rate notes may also provide diversification benefits due to their low historical correlation to traditional fixed income asset classes like US Treasury bonds (-0.18) and the Bloomberg US Aggregate Bond Index (0.18).5
Consider Floating-Rate ETFs
Investors with conviction in floating-rate notes may want to consider the SPDR® Bloomberg Investment Grade Floating Rate ETF (FLRN), which seeks to provide exposure to debt instruments that pay a variable (i.e., floating) coupon rate based on prevailing short-term market rates plus a fixed spread.
In the last Fed tightening cycle that ran from late 2015 through the end of 2018, rates rose from 0.25% to 2.50%. During the same time period, FLRN’s index had positive monthly performance in 33 of the 37 months (90%). And the yield increased alongside it, going from 91 to 361 basis points.6
Since 2003, FLRN’s index has, on average, outperformed short-duration government and corporate bonds as well as the Bloomberg US Aggregate Bond Index during months when the 2-year Treasury yield increased (see chart above). This trend for floating-rate exposures has continued, with FLRN down just -0.61% while the Agg is down -11.48% year to date.7
With the prospect of another aggressive rate hike next month, now may be the time to give floating-rate notes a closer look.
FLRN Standard Performance as of June 30, 2022
1 Federal Reserve Implementation Notes, as of June 15, 2022. 2 Bloomberg Finance L.P., as of June 20, 2022. 3 Federal Reserve Implementation Notes, as of June 15, 2022. 4 Bloomberg Finance, L.P., as of March 31, 2022. Past performance is not a reliable indicator of future performance. 5 Bloomberg Finance, L.P., as of March 31, 2022, as measured by the correlation of monthly returns for the Bloomberg USD Floating Rate Note < 5 Years Index to the Bloomberg Barclays US Treasury Bond Index and the Bloomberg US Aggregate Bond Index, from October 31, 2003 to March 31, 2022. The correlation coefficient measures the strength and direction of a linear relationship between two variables. It measures the degree to which the deviations of one variable from its mean are related to those of a different variable from its respective mean. All the index performance results referred to are provided exclusively for comparison purposes only. It should not be assumed that they represent the performance of any particular investment. 6 Bloomberg Finance, L.P., October 31, 2003 to March 31, 2022. Past performance is not a reliable indicator of future performance. All the index performance results referred to are provided exclusively for comparison purposes only. It should not be assumed that they represent the performance of any particular investment. Index returns reflect capital gains and losses, income, and the reinvestment of dividends. Index returns are unmanaged and do not reflect the deduction of any fees or expenses. 7 Bloomberg Finance L.P., as of June 20, 2022.
Floating-Rate Note A debt instrument with a variable interest rate. Also known as a “floater,” a floating-rate note’s interest rate is tied to a benchmark such as the US Treasury bill rate, LIBOR, or the Fed funds or prime rate. Floaters are mainly issued by financial institutions and governments, and they typically have two-to five-year terms to maturity. They typically carry lower yields than fixed notes of the same maturity. The rates for floating-rate note reset or adjust periodically, normally on a daily, monthly, quarterly or semi-annual basis.
This post was written with contributions from Ronnie Kuriakose. Ronnie is a research analyst on the SPDR Americas Research team.
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