As investors seek yield in short-term certificates of deposit and Treasury bills, they should be aware of another fixed income play that takes advantage of today’s higher interest rates. Enter the humble floating rate note. These instruments are fixed income securities that pay a coupon based on a reference rate that resets periodically. These can be issued by financial institutions, corporations and the federal government, typically coming in at 2- to 5-year maturities. “Floating rate notes can be used to lower the overall duration of an investor’s fixed income portfolio,” said Allison Bonds, head of private wealth management and independent wealth management at State Street’s U.S. SPDR ETF business. Duration, which is measured in years, is the gauge of a bond’s price sensitivity to interest rate changes. Bond prices move opposite their yields, and issues with longer duration are more likely to see price swings as rates change. For floating rate notes, the duration is close to zero, while the fixed rate corporate bond market has a duration of 7½ years, Bonds said. Floating rate notes’ short duration gives them a measure of relative price stability, while offering investors’ portfolios some support through variable income. Still, the market is a small one compared to better-known fixed income plays amid rapidly rising rates: The iShares Floating Rate Bond ETF (FLOT) has about $7 billion in assets, while the iShares 1-3 Year Treasury Bond ETF (SHY) has $27 billion in assets, according to FactSet. “Flows have been more muted in 2022 and 2023, likely due to the speed of the current hiking cycle, which has been the fastest in decades, making cash itself a more attractive opportunity to earn income,” Bonds said. A bet on higher rates The Federal Reserve foresees two more rate hikes this year, according to its latest dot plot . That’s on top of the 10 rate increases it’s put in place since March 2022. Fed Chair Jerome Powell recently indicated that he sees more hikes coming, saying, “Inflation pressures continue to run high, and the process of getting inflation back down to 2% has a long way to go.” It’s the prospect of higher rates for longer, along with the inverted yield curve, that make floating rate notes an attractive play for some. “This is my personal view, but I don’t see rate cuts,” said Paul Winter, certified financial planner and president of Five Seasons Financial Planning. “If we do get them, I don’t see us going back to zero on the federal funds rate.” For his clients, Winter has committed a quarter to a third of investors’ fixed income allocation to floating rate notes. He prefers using exchange traded funds to get the exposure, citing more liquidity compared to buying individual issues. Where you keep these notes also matters: The interest they generate is taxed as ordinary income, which has a top marginal rate of 37%. These investments are better contenders for tax-deferred accounts like your individual retirement account, rather than your taxable account. Income, price stability, tame returns In a falling rate environment, floating rate notes may generate lower coupon payments, and total returns may be less than anticipated if future interest rate expectations aren’t met, Bonds said. There is also some concern around reinvestment risk: Once the Fed begins cutting rates, could investors be left without a source of attractive yield if they haven’t locked into a longer-term fixed income asset? “It’s lower coupon rates versus the opportunity to lock in high fixed rates now if you consider the environment,” said Collin Martin, fixed income strategist at Charles Schwab. “Based on updated projections that the Fed is close to the end of the rate hiking cycle, there isn’t much room for the coupons to rise.” Finally, opportunities for price appreciation are also limited — which is another factor for investors to weigh. “If you remember Covid and the great recession of 2008, high quality bonds experienced price appreciation,” said Winter. “There was a flight to quality and people fled to Treasurys.” That means in a recession, you may not get an increase in floating rate note prices to offset a decline in equities, he said.
This story originally appeared on CNBC
