Floating Rate Funds to Avoid Interest Rate Risk

NEW YORK ( TheStreet) -- The fixed income market is clearly in a state of flux and confusion.

The yield on the 10-year U.S. Treasury note has gone up meaningfully in the last few weeks but still well below historical norms. Investors interested in still maintaining a diversified asset allocation need fixed-income exposure but a popular fund like the iShares Barclays 20+ Year Treasury Bond ETF ( TLT) will be in for more losses if rates continue to go up.

Two funds that could spare investors this pain are the Market Vectors Investment Grade Floating Rate ETF ( FLTR) and the iShares Floating Rate Note ETF ( FLOT). In the last seven weeks as TLT declined more than 12%, both FLTR and FLOT each went down less than 0.20%. The current bond market panic is a reasonable litmus test.

The big idea with floating rate debt is the interest rate resets as outlined in the bonds' covenants with changes in the open market. The benefit to the issuers is that it allows them to issue competitively priced debt and creates demand for their debt. The benefit for investors is these issues should not be hurt by rising rates the way plain vanilla bonds would be.

The history of floating rate debt is that it has been high-yield debt, but both FLTR and FLOT own corporate, investment grade debt. FLOT also has small exposures to supranational debt like a AAA-rated issue from the International Bank for Reconstruction and local authority debt including a Province of Ontario issue.

Most of the holdings will be more familiar and are similar in both funds including JPMorgan ( JPM), Citigroup ( C) and Goldman Sachs ( GS).

FLTR and FLOT are both very heavy in financials at 82% and 58%, respectively. Those are both large allocations to financials, which might raise concerns should there be some sort of repeat of 2008. While banks today are not as healthy as they were 10 years ago, many contributing factors to the crisis have been mitigated in terms of bank viability.

FLTR and FLOT also own debt from foreign companies denominated in U.S. dollars. These issues in both funds are mostly Australian and Canadian bank debt and to a lesser extent European bank debt.

The yield for these funds is now quite low. FLTR yields 0.57% and FLOT yields 0.38%. As low as that seems, it is competitive with short-dated, corporate, investment grade debt.

One important difference between the funds could be the expense ratios. The iShares fund has a straightforward 0.20% fee. FLTR has a fee that is capped at 0.19% until Sept. 1, when it could go up to 1.92%. Many Market Vector funds have a capped expense like this and the company has always extended them; it has never raised the fee on a fund before.

In that light it is reasonable to expect FLTR will be handled the same way but no guarantee. Obviously at current rates, allowing the fee to rise would take the yield to zero which would trigger an exodus from the fund.

For the last few years investors have chased yield with little to no consequence but the threat has always been there. The yields of these funds are low for now but if rates really are headed higher then protection will be more important than yield. At some point rates at all-time lows must normalize and if that is starting to happen now then these funds should offer that protection.

At the time of publication the author had no position in any of the stocks mentioned.

This article was written by an independent contributor, separate from TheStreet's regular news coverage.