This article (and others by Brad Zigler)
in the September issue ofREP. magazine and on
Forget what your Mom told you. You can float through life.
That's the message the
have been sending investors over the past 18 months.
Thanks to some recently introduced exchange-traded products,
you can make either side of your portfolio-equity or debt-float.
So to speak.
Perhaps some definitions are in order because the word "float"
means something different to stock investors than it does to
bondholders. On the equity side, float refers to the number of
company shares held by the public. Float, on the debt side, most
typically describes coupons that periodically reset to market
Either way, there's money to be made playing the float game,
especially when you decide to float both sides of your
Rates That Float
Earlier this year, the Federal Reserve started, um, floating
test balloons to signal an increasing likelihood of higher rates.
The effect on a now-spooked credit market was dramatic. Between
March and June, 10-year Treasury rates backed up more than 60 basis
points, knocking down bond and bond fund prices.
Floating rate notes (FRNs), however, held their ground. FRNs,
also known as senior loans, leveraged loans or syndicated bank
loans, represent bank credit extended to corporations with
below-investment-grade ratings. These loans are often used in the
financing of leveraged buyouts, mergers and acquisitions. They're
known as senior loans because investors' rights to the payment of
principal and interest is senior to any other security in the
issuing corporation's capital structure. They're syndicated because
the risk is spread around to a group of banks and institutional
Interest paid by FRNs adjust to the current market by being
tethered to a reference rate, typically the London Interbank
Offered Rate, or LIBOR. Most often, an FRN will offer a yield at
some preset margin over the reference. As an example, J.C. Penney
Co., Inc. (
), a B2/B- credit, has an "L+500" note outstanding, meaning it pays
LIBOR plus 500 basis points.
Reference rates are typically reset every 30, 60 or 90 days,
keeping the FRN yield in line with changes in the corporate credit
market. That's a benefit to be especially enjoyed by noteholders in
a rising rate environment. Of course, it could be a bit of a
detriment when interest rates are falling, though FRNs tend to be
less rate-sensitive than other segments of the bond market.
FRNs can diversify a portfolio's fixed income allocation
(though, as we'll soon see, it may take a whole lot of them to
provide a meaningful effect) because these notes commonly have very
low or negative correlations to broader segments of the credit
More often than not, FRNs are secured by collateral such as
property, inventory or equipment. That feature, coupled with the
loan's senior status and any embedded performance or
leverage-related covenants, mitigates a holder's risk. That makes
FRNs an appealing alternative to high-yield (junk) bonds.
All this shouldn't lead investors to ignore the inherent risks
presented by FRNs. These are, after all, loans extended to
low-rated companies. There's still big credit risk here, even if
it's a notch below junk paper. Of course, improving economic
conditions and strengthening corporate balance sheets will tend to
narrow credit spreads and bolster FRN values, but deterioration
will have the opposite effect.
Floating Rate ETPs
Investors can tap into the FRN market through a growing number
of exchange-traded products. First to market was the PowerShares
Senior Loan Portfolio (
), launched in March 2011. The passively managed ETF tracks the
S&P/LSTA U.S. Leveraged Loan 100 Index, a market-weighted
benchmark of the nation's largest institutional notes.
The $4.8 billion BKLN fund presently offers an annual yield of
4.6 percent after expenses of 66 basis points. The fund's
components average a reset cycle of 48 days.
To say that BKLN has been popular lately is a bit of an
understatement. As interest rates ratcheted up, the fund raked in
nearly $500 million a month making it the nation's eighth-largest
corporate bond ETP.
Dramatic asset growth also has been seen in more recently
launched bank loan products, namely the passively managed
Highland/Boxx Senior Loan ETF (
) and two active products, the SPDR Blackstone/GSO Senior Loan ETF
) and the First Trust Senior Loan Fund (
). This asset surge has come at the expense of the high yield
market especially. In the first half of 2013, for example, the
largest junk bond ETPs, the iShares iBoxx $ High Yield Corporate
Bond ETF (HYG) and the SPDR Barclays High Yield Bond ETF (JNK),
lost $1.7 billion and $2.9 billion, respectively.
Float vs. Junk
In its first 18 months, BKLN returned substantially more than
the general bond market, proxied by the iShares Core Total U.S.
Bond Market ETF (AGG), and edged out the high yield segment
represented by HYG. Both HYG and BKLN are negatively correlated to
AGG, though BKLN is more so. BKLN's low volatility earns the fund a
Sharpe ratio more than double that of HYG, indicating a much better
reward-to-risk proposition in the FRN market versus the high-yield
Public companies, flush with cash after trimming costs during
the financial crisis, are now buying back their shares in record
numbers. If equity floats your boat, a couple of exchange-traded
funds will let you ride atop the buyback wave.
The actively managed AdvisorShares TrimTabs Float Shrink ETF
(TTFS) is the newest float-playing entrant to market. TTFS
portfolio runners look for companies actively engaged in float
reduction through buybacks rather than reverse stock splits or
spin-offs. Specifically, TTFS managers want issuers generating free
cash flow from operations and shun those using leverage to shrink
their share base.
The fund's bogey is the Russell 3000 Index which is used as the
universe from which purchase candidates are culled. First, the
index is screened for float reducers, then the illiquid
issues-stocks with low trading volumes or exceptionally high
bid/ask spreads-are tossed. Finally, capital is allocated equally
to each of the 100 top-ranked companies passing the screens.
TTFS is a young fund but, as its track record shows, it's
managed to reach its objective. Over the past 18 months, TTFS
earned enough excess return to overcome its higher volatility and
edge out the low-cost Vanguard Russell 3000 Index ETF (VTHR).
A more passive approach is taken by the PowerShares Buyback
Achievers Portfolio (PKW). PKW tracks a modified
capitalization-weighted benchmark comprised of companies that have
repurchased five percent or more of their common stock in the past
The fund aims to outperform the S&P 500 and charges an
expense ratio of 70 basis points, a cheaper alternative to the
99-basis point TTFS portfolio. Cheap isn't necessarily better,
however. Because of its lower volatility, PKW earns a better Sharpe
ratio than TTFS but, at the same time, is more highly correlated to
the broad market. PKW posted a .96 correlation coefficient versus
the SPDR S&P 500 (SPY) for the past year and a half, making the
PowerShares fund less desirable as a portfolio diversifier compared
Two Better Than One
Recent punditry has extolled the virtues of FRN funds as fixed
income portfolio diversifiers. Float reduction ETFs have been less
visible among market observers and investors but are still
advertised as risk management tools.
You've got to add heavy spoonfuls of these products, however,
for optimum results. Yes, small doses boost overall returns, but
they also crank up portfolio volatility. Still, there is a sweet
spot, where returns justify the risk undertaken.
Let's look at what a portfolio might look like if it were
allowed to totally "float." If you swapped out index funds in the
classic 60/40 (equity/fixed income) model with float products,
returns would have been boosted by a third over the past 18
The total replacement of broad market exposure with float
products, in this case TTFS and BKLN, would have increased returns
with just a modest goose-up in overall volatility. The incremental
gains, of course, are cyclical which is to say that market
conditions favored both products over the sample period. Why?
Because TTFS and BKLN are positively correlated, a synergy that
magnified returns. A more traditional portfolio made up of the SPDR
S&P Mid-Cap 400 (MDY)-the "best fit" market proxy for the
medium capitalization-tilted TTFS-and the iShares AGG fund is more
disparate. MDY and AGG are negatively correlated, a condition that
may yield more portfolio risk diversification over the long
An investor taking the total replacement approach would have to
be gutsy and perhaps a bit speculative. The portfolio isn't a
buy-and-forget proposition. Sooner or later, the recovery bloom's
bound to fade and interest rates will stabilize, all of which may
chip away at the float products' present advantage. For
not-so-sanguine investors, giving over less portfolio real estate
to float products may be more comfortable. But what's the optimum
allocation? What mix of float products produces the best
If we use the Sharpe ratio as our yardstick and the past 18
months as our market environment, you'd need a substantial dollop
of float products to get out to the fringe of the efficient
frontier. A very substantial dollop.
True, allocating small amounts to TTFS and BKLN in a 60/40
portfolio has an ameliorative effect on returns, but the
overarching step-up in volatility dampens Sharpe ratios. A 10
percent allocation to each, for example, produced a 14.5 percent
annual return but only a 1.61 Sharpe ratio. Doubling the
allocations to 20 percent yields an annual return of 15.4 percent
together with a 1.74 Sharpe ratio. It's only when the debt side of
the portfolio (40 percent) is given over totally to BKLN and the
TTFS apportionment cranked up to 30 percent or more that we see
Sharpe ratios exceeding that full-float portfolio's. As it turns
out, that sweet spot is hit with a mix of 40 percent TTFS, 20
percent MDY and 40 percent BKLN.
Few investors or financial advisors may be interested in
building portfolios of such limited scope, but the foregoing
examples do illustrate the utility of float products. At least in
the current environment. The biggest exogenous risk to a float
portfolio is an economic downturn in which buyback cash dwindles
and credit quality nosedives. At that point, float products would
likely need to be swapped out of portfolio for more defensive
At least, that's what Mom would say if she were your
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