FLTR: Higher For Longer And Reaching For Quality

Written by Nick Ackerman, co-produced by Stanford Chemist.

The VanEck IG Floating Rate ETF (NYSEARCA:FLTR) provides investors exposure to floating rate note investments, but those come with a high-quality investment grade rating. While we tend to focus on senior loan CEFs and ETFs that invest more in junk-rated loans, there is still a universe that exists that provides floating rates to investors with higher quality ratings. That’s where FLTR can come in to provide this type of exposure.

This can mix the best of both worlds, where “higher for longer” is no problem but also where a “hard landing,” with a rapid slowdown in the economy, could also keep an investor’s capital protected. The idea here is that if rates remain high, the higher income will continue to roll in for investors, but at the same time, should the economy falter rapidly, the portfolio should experience relatively limited defaults.

FLTR Basics

• Dividend Frequency: Monthly
• Dividend Yield: 5.95% (SEC yield)
• Expense Ratio: 0.14%
• Leverage: N/A
• Managed Assets: $1.43 billion
• Structure: Passive ETF

FLTR’s investment objective is to “replicate as closely as possible, before fees and expenses, the price and yield performance of the MVIS US Investment Grade Floating Rate Index (MVFLTR), which consists of U.S. dollar-denominated floating rate notes issued by corporate issuers and rated investment grade.”

As a passive fund, it comes with an incredibly low expense ratio of just 0.14%. That is well below the ETF average of around 0.50%. That should mean pretty limited slippage in terms of underperformance relative to the index it tracks. In fact, the fund has actually delivered some alpha over the last 1 and 3 years.

Performance Comparison

When looking at FLTR, we can see the massive benefit the fund had over its fixed-rate counterparts. In particular, the iShares iBoxx Investment Grade Corporate Bond ETF (LQD) would have provided negative returns over the last three years. The iShares National Municipal Bond ETF (MUB) also had negative returns but was essentially flat. However, during this same period, FLTR provided a nice ramp-up in terms of total returns.

Of course, this was nothing like equity returns during this period, but the securities they are investing in are much higher in the capital stack and investment grade. You’re not looking to get a blow-out performance with this type of investment.

This is all driven by interest rate sensitivity, which is measured by duration. The effective duration for FLTR is actually -0.12 years. I have to admit that I don’t recall ever seeing a negative duration before, even after following a number of floating-rate funds. That essentially means that as rates increase, the underlying price of FLTR’s holdings should also increase.

However, elsewhere on the fund’s site, they listed the modified duration at 0.13 years, which is more of what I would expect to see.

In contrast, LQD’s effective duration is 8.31 years, meaning that for every 1% change in rates, the portfolio would expect to fall or rise about 8.31%. For MUB, their effective duration is 6.11 years.

Interestingly, over the last decade, the performance of all three of these funds converged to an identical level.

Besides holding up better thanks to its lower interest rate sensitivity relative to fixed-rate income, the portfolio’s income generation got a huge boost as well. The yield has easily exceeded what LQD and MUB can deliver. As we can see in the previous somewhat short-lived rate hiking cycle that was much more moderate with increases, it really didn’t take much for FLTR to start out-yielding MUB and become competitive with LQD.

All About The Fed Target Rates

If one believes that interest rates are going to be cut quite quickly, then an investment such as LQD or MUB would have much better prospects going forward.

On the other hand, the projections for rate cuts continue to get pushed back, and now there is some real doubt that we could even see rate cuts this year. Those elusive cuts may have to be put off until next year, in 2025, in which case FLTR could likely continue to deliver a respectable yield to investors. Even after a few initial rate cuts, FLTR would still deliver a higher yield relative to its fixed-rate counterparts.

One of the risks to consider about rate cuts is if the Fed needs to cut rates aggressively. At this time, it isn’t projected to be more than a few cuts this year and a couple more next year. Therefore, it seems highly unlikely that we will go back to a zero-rate environment.

With that said, should the Fed need to cut so aggressively, it is likely because the economy is faltering and faltering quickly. That’s where the fund’s high-quality tilt toward investment-grade holdings can come in to protect investors.

Not only are you quite high up in the capital stack with this portfolio, but the quality here is primarily A-rated credit and above. However, a quarter of the sleeve is in BBB, which is the first rung into investment-grade quality.

Most of the fund’s top holdings reflect this as well. The fund is invested in the type of companies, several of the G-SIBs, indicating that if they are failing and defaulting, then we are in a nightmare world of economic hurt.

The portfolio spiked down during Covid, but the recovery from that low was astonishingly quick.

Finally, another angle to consider is rate increases. It is highly expected that the Fed is at its peak target rates for this cycle; however, more hikes in the future can’t be ruled out completely either. It is all dependent on the data, but if we do get rate hikes, then this fund should start to deliver even more income to investors. So it is a hedge in that way, too, which we already saw play out over the last three years during a period of rapidly increasing interest rates.

Conclusion

FLTR is delivering a solid income yield to investors while rates remain higher. If rates remain “higher for longer,” which is likely, then FLTR can remain a solid place to put some capital into work. Even with a few cuts that are projected over the next year currently, FLTR would likely still be delivering a superior yield relative to its fixed-rate peers.

Thanks to this portfolio’s high-quality investment-grade tilt, there is less risk in a slowing economy. I believe the main risk is in a scenario where the Fed is pushed to cut rates aggressively, and its fixed-rate peers could outperform. That said, FLTR’s portfolio is likely to experience only limited defaults and losses under a more typical recession.