New ETFs are hedged against credit and interest rate risk

iShares, Wisdomtree launch new funds taking advantage of the government's new floating-rate notes

Feb 7, 2014 @ 12:10 pm

By Carl O'Donnell

New exchange-traded funds from BlackRock Inc. and WisdomTree Investments Inc. are offering easy access to a new class of Treasury bonds that guard against both credit and interest rate risk.

The iShares Treasury Floating Rate Bond ETF (TFLO) from BlackRock and the WisdomTree Bloomberg Floating Rate Treasury Fund (USFR) debuted on Feb. 4 and offer exposure to two-year floating rate Treasury bonds, a new breed of U.S. debt that was unveiled on Jan. 29.

These Treasury bonds offer protection from interest rate volatility by issuing semiannual coupon payments that adjust based on the interest rate of the 13-week T-bill. Traditional bonds, conversely, pay a fixed coupon and therefore drop in price when the interest rate increases, said Barry Fennell, a senior research analyst at Lipper Corp.

“These are very safe products, guarded against both credit and interest rate risk,” Mr. Fennell said.

Both ETFs charge expense ratios of 0.15%. For the next year, Blackrock Inc. has suspended the expense ratio on TFLO. Todd Rosenbluth, director of ETF and mutual fund research at S&P Capital IQ, said the suspension, combined with Blackrock's larger base of existing fixed-income ETFs, might give the iShares ETF an upper hand in attracting liquidity.

No matter the sales pitch, the new ETFs are not risk-free. In fact, if interest rates were to unexpectedly fall for some reason, as they did in January, investors in these floating rate ETFs would lose out, Mr. Rosenbluth said.

So investors need to watch out for downward corrections in U.S. equities, or further tumult in emerging markets, either of which could cause a “flight to quality” that could pressure rates, he said.

The best-case scenario for holders of these ETFs would be unexpectedly positive macroeconomic news that prompts the Federal Reserve to raise interest rates faster than expected, Mr. Fennell said. Fed officials have indicated they are not planning on increasing rates anytime soon.

Currently, the government has issued only $15 billion in floating-rate bonds but the supply is likely to increase, Mr. Fennell said, with these securities gradually replacing 90-day T-bills.

“As China and Japan see dwindling trade surpluses, and the Middle Eastern oil producers see less revenue, foreign demand for our debt is declining,” Mr. Fennell said. “The government is relying more on domestic investors, and these new securities are a way to appeal to them.”

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