FLRN - FLRN: Simple Investment-Grade Floating Rate ETF 5.8% SEC Yield Low Interest Rate Risk

2023-07-26 04:51:00 ET

Summary

• FLRN invests in investment-grade floating rate bonds.
• The fund has very little in interest rate risk and credit risk and sports a 5.8% SEC yield / forward yield.
• An overview of the fund follows.

The SPDR Bloomberg Investment Grade Floating Rate ETF (FLRN) is a simple investment-grade, floating rate, index ETF. FLRN's very low interest rate / credit risk, and comparatively strong 5.8% SEC yield, make the fund a buy.

FLRN - Overview and Analysis

Low Interest Rate Risk

FLRN invests in floating rate bonds which, by their very nature, have low interest rate risk. To explain why, some context first.

Most bonds and bond funds pay a fixed rate of interest for their entire duration, until maturity. When the Federal Reserve hikes rates , or when rates move in anticipation of Fed hikes, only the interest rate payments on newly issued bonds change. Older bonds retain their original interest rates.

Floating rate bonds, on the other hand, pay a floating rate of interest. Interest rate payments are indexed to a specific reference rate, usually the secured overnight financing rate, or SOFR. Said rate is meant to track interbank lending rates but, for all intents and purposes, is equivalent to the Federal Reserve target rate.

So, when the Fed hikes rates SOFR goes up, and so does the interest rate on most floating rate bonds. Rates are reset quarterly, so the process might take a few months.

Funds focusing on floating rate bonds tend to see strong dividend growth when interest rates rise, due to higher interest rate payments on their underlying holdings. Funds focusing on fixed rate bonds should see some growth too, as their older, lower-yielding bonds mature and are replaced with higher-yielding alternatives. Growth should be much weaker, as it generally takes years for a fixed rate bond to mature, but months for a floating rate bond to reset. FLRN saw much higher dividend growth than its peers in 2022, a period of rising interest rates, as expected.

Growth was much higher when looking at dividend yields directly. FLRN's yield increased from 0.39% to 1.95%, so 1.56% in growth. The iShares iBoxx $ Investment Grade Corporate Bond ETF ( LQD ) saw growth of 1.00%, the iShares 1-5 Year Investment Grade Corporate Bond ETF ( IGSB ) growth of 0.25%.

Floating rate bonds and fixed rate bonds react differently to interest rate movements, and so market reactions are different too. Fixed rate bonds tend to see cratering prices when rates rise, as investors sell their older, lower-yielding bonds, to buy newer, higher-yielding alternatives. Floating rate bonds, on the other hand, tend to see relatively stable prices, as investors stay put in anticipation of higher yields. FLRN's price decreased by a measly 0.65% in 2022, compared to losses of over 20% for LQD. Other bonds and bond funds saw significant losses too.

FLRN's floating rate bonds have very low interest rate risk, and so the fund tends to outperform when interest rates are rising. This is an important positive for shareholders, although, as rates are stabilizing, investors are unlikely to see any short-term benefit from this. It remains a positive, and one of particular use to more risk-averse long-term investors.

On a more negative note, FLRN's very low interest rate risk means the fund tends to underperform when interest rates decrease . Rates can go down for a variety of factors, including Fed rate policy and expectations thereof, as well as economic and market conditions / events. Rates declined in 2020, as the Fed slashed rates in the face of the coronavirus pandemic. FLRN underperformed during said year, as expected.

Investors expect the Fed to cut in 2024 , and have priced bonds accordingly. As such, rate cuts might not necessarily lead to underperformance for FLRN moving forward, at least not if these are small, and within expectations.

Low Credit Risk

FLRN focuses on investment-grade bonds with strong credit ratings, and low default rates. FLRN's holdings sport an average credit rating of A, compared to BBB for most investment-grade bond funds.

FLRN's high-quality holdings tend to be relatively safe, stable investments, and resilient in the face of adverse economic and market conditions. Expect comparatively few losses during these, as was the case in 1Q2020, the onset of the coronavirus pandemic. On a slightly more negative note, the fund does not benefit from a flight-to-quality effect when markets are down, unlike treasuries.

Stable Share Price / Shareholder Capital

FLRN has very little in interest rate and credit risk, which results in an incredibly stable share price. Shares almost always trade between $30.20 and $30.50, a very tight range. Price dropped below $30.00 for several days in early 2020, almost entirely due to a widening discount caused by market volatility. NAVs were much more resilient.

FLRN's NAV is much more stable than that of most bonds, slightly more volatile compared to T-bills.

ETFs are structured so as to minimize discounts and premiums. Large discounts are rare, and almost always temporary in nature. As such, I think it is fair to say that FLRN (almost always) is a safe, stable investment, with an incredibly stable share price. This is an important benefit for all investors, and particularly relevant for more risk-averse, short-term investors wishing to safeguard their capital.

Good Dividends and Dividend Growth

FLRN's dividends are reasonably good, with the fund sporting a 4.3% dividend yield, and a 5.8% SEC yields. Dividend yields are backwards-looking metrics, which take into consideration dividends paid in the last twelve months. SEC yields measure the actual income generated by the fund's underlying holdings in the past month, and so are much more informative, pertinent figure for investors moving forward.

FLRN's dividends compare favorably to those of its peers, with the fund yielding more than most other safe, high-quality bond index funds. Importantly, the fund yields 0.50% more than LQD, the largest fixed rate investment-grade ETF in the market. As emphasis, this means that floating rate investment-grade bonds yield 0.50% more than fixed rate investment-grade bonds, and that is with much lower interest rate risk.

FLRN yields more than LQD, even though both funds have comparable credit risk, as investors expect Fed rate cuts in 2024. Lower Fed rates would almost immediately lead to lower rates on FLRN's underlying holdings, less so for LQD, leading to more equal dividends between these two funds.

Notwithstanding the above, I see FLRN's comparatively strong dividends as an important positive. The fund yields more than its closest peers right now , which benefits investors right now . Rates could always, potentially, change in the future, but this is not certain, and several rate cuts are priced-in already. FLRN seems safer, and higher-yielding too.

As a final point, FLRN's dividends should see further growth moving forward, due to the Fed's most recent 0.25% hike, and due to a probable hike in the coming months. Growth is likely to be modest, and dependent on future Fed policy, which is not set in stone.

Performance Track-Record

FLRN is an income vehicle, whose returns almost entirely consist of dividends. FLRN focuses on investment-grade bonds, which tend to sport low rates, and generate low dividends. Rates were very low in the past, as the Fed kept rates at zero to stimulate the economy in the aftermath of the financial crisis / housing bubble, and the pandemic. Due to this, the fund's long-term returns are quite weak, at 1.50% - 1.60% per year for the past decade. Rates have risen these past few years, as have fund returns, with FLRN seeing returns of 5.3% - 6.1% these past twelve months.

In the short-term, FLRN's returns will be closer to the more recent 5.0% - 6.0% values, in-line with Fed policy. Long-term returns will depend on long-term Fed rates, forecasts of which are outside the scope of this article.

Conclusion

FLRN is a simple investment-grade, floating rate, index ETF. FLRN's very low interest rate / credit risk, and comparatively strong 5.8% SEC yield, make the fund a buy.

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