Looking to shield your investment portfolio from the prospect of higher interest rates in the near future?
The chance to do that is being offered by three new Invesco exchanged-traded funds investing in a special type of bond called floating rate notes.
As the name suggests, floating rate notes, or FRNs, have variable interest payments that change periodically to reflect movement in interest rates. So if rates go up, the bond’s interest payments – called the coupon – follows suit and vice versa.
Interest rate shield: The ETFs invests in a special bond called floating rate notes which pays variable interest that change periodically to reflect movement in interest rates
This differs from conventional bonds, which offer a fixed rate of interest – so their value falls when rates increase.
Interest payments for FRNs are based on a floating reference rate, such as LIBOR (the London Interbank Offered Rate), plus an additional bit on top of that.
Charges on the three new products range between 0.1 per cent and 0.12 per cent.
But these funds are not targeted at the average UK investor. They are skewed to those who want to take positions on the direction of interest rates in the US or Eurozone rather than in the UK.
Only one is traded on the London Stock Exchange but it is denominated in US Dollars and focused on US Floating Rate Notes.
The other two trade using the Euro currency which has recently been buffeted by political turmoil in Italy and Spain.
The trackers are likely to incur higher than average trading costs as brokers typically levy more to convert foreign currency returns back into pound sterling.
What does the ETF invest in?
Passive investments seek to replicate the performance of a given index like the FTSE 100. They are often referred to as trackers for this reason.
Here, the three ETFs operate slightly differently. They are based on the respective dollar and euro denominated Bloomberg Barclays FRN indices, but with a few refinements.
|ETF||Exchange||Trading currency||Ongoing charges|
|Invesco USD Floating Rate Note UCITS ETF||London Stock Exchange||USD||0.10|
|Invesco USD Floating Rate Note UCITS ETF – EUR hedged||Xetra||EUR||0.12|
|Invesco EUR Floating Rate Note UCITS ETF||Xetra||EUR||0.12|
Only FRNs that attempt to raise a least £500 million (or €500 million) make the cut for ‘liquidity’ purposes according to Invesco. This essentially means that the fund house is only interested in bonds that it can buy and sell relatively easily.
The ETFs must also have a least two and a half years until maturity – when the principal payment and the last round of interest payment are due.
In addition, the FRN must be removed from open market two and a half years after being issued to encourage active trading.
How do they compare?
It’s a niche product but there are a handful of ETFs investing in FRNs in market.
The iShares Floating Rate Bond ETF and the SPDR Bloomberg Barclays Investment Grade Floating Rate ETF are among the largest. They both invests in U.S. dollar-denominated investment-grade FRN, but only those with remaining maturities between one month and five years.
They track the Bloomberg Barclays US Floating Rate Note < 5 Years index and have ongoing charges of 0.12 per cent and 0.15 per cent respectively.
So both products are more expensive than the Invesco USD Floating Rate Note UCITS ETF (0.10 per cent).
The funds have not performed spectacularly well – then again, bonds are generally designed to provide income and security to portfolios, while shares are there to provide growth.
The iShares ETF, which launched in September last year, returned 0.25 per cent since inception (to 4 June), while the SPDR ETF returned 5.5 per cent over five years.
As well as passive trackers, investors can consider the active funds investing in FRN. They are typically more expensive though.
This is Money Verdict
After years of almost 0 per cent interest rates (and negative rates in some foreign markets) in the wake of the devastating financial crisis in 2008, it would appear that the only way is up for interest rates.
FRN ETFs may seem like the ideal solution for investors who are skittish about interest rate hikes and the potentially erosive effects on their portfolios, but as mentioned before, these funds aren’t targeted to the average investor.
If shielding your portfolio from increases from interest rates is your goal, their are alternative avenues worth exploring.
Jason Hollands, managing director of financial firm Tilney, said: ‘Steer clear of Gilts [UK government bonds] for starters and make sure any bond funds you hold are positioned with short duration and have the flexibility to adapt as the rate environment evolves.
‘A good example would be TwentyFour Dynamic Bond fund. Some of the lower volatility multi-strategy targeted absolute return funds are also tasked with delivering returns in excess of cash and inflation, such as Invesco Perpetual Global Targeted Returns.
But if you’re wedded to investing in one of these funds, here are some of the key considerations.
The ETFs are denominated in a foreign currency, there is a real risk of paying more in trading costs. This could wipe a significant chunk off your take home return as some leading brokers levy up to 1.5 per cent in foreign exchange charges.
You may also want to have a view of whether the sterling is strong or weak. This is because you would get lower returns if you buy into assets in a currency that is weaker than the sterling when it is converted back to pounds and pence.
Some brokers levy up to 1.5 per cent in foreign exchange charges
The euro hedged ETFs take the foreign currency return out of the equation through a complex process involving derivative contracts, but it costs more than the unhedged option.
Peter Sleep, senior investment manager at Seven Investment Management, said: ‘An investor may want to speak to their friendly neighbourhood financial planner on these products as there are a number of decisions to make on currency, US and European inflation and interest rates, cost of hedging and overseas creditworthiness to think about.
‘I would suggest that a UK investor can easily rule out Invesco USD Floating Rate Note UCITS ETF – EUR hedged.
‘I am not too sure why an investor would want a euro denominated product as the euro can be whipsawed by developments in Greece, Italy or even Russia. You could argue it might be a diversifier, but I think there are better ways to diversify.’