One word has sent fear screaming back into the markets- taper.
To get any sort of real yield in the current low rate environment, investors have been forced to go out on the maturity ladder and into longer-dated bond funds like the iShares Barclays 7-10 Year Treasury (NYSE:IEF). However, as the Federal Reserve has now begun seriously talking about ending its QE program and raising rates, investors in these longer dated bond funds could see some serious capital losses. Income seekers are certainly in a tight spot.
Luckily, there's plenty of ways to get higher yields and interest rate protection.
A Big Issue
While deep-down the Fed’s impending actions are actually a good thing- meaning he economy is finally moving in the right direction- they can cause some unpleasant side effects for fixed income seekers. Bond prices are inversely correlated with the direction of interest rates. As the Fed raises rates, a portfolio of fixed-income securities will likely lose value. Bonds with longer maturities suffer more. The longer the maturity of the bond, the bigger the swing in prices.
SEE: Translating "Fed" Speak Into Plain English
For example, every percentage point gain in yield, a 10-year bond would lose roughly 10% in price, meanwhile a 30-year bond would drop around 30%. Those are some hefty losses for what many investors consider safe-haven investments. With cash, CDs and short-term investment funds like the PIMCO Enhanced Short Maturity ETF (NASDAQ:MINT) paying next to nothing, investors looking to fund their liabilities today are facing a quandary.
However, there are some ways to help insulate a portfolio from rising interest rates. Investor's first can look for bonds that have above-average yields and below-average durations. Duration is a way to measure debt issues' price sensitivity to interest-rate movements. By using the duration metric, investors are able to compare bonds across a variety of maturities and coupons. In addition, bonds with higher yields are generally less affected by movements in short-term interest rates.
Adding the Protection
The first option that help mitigate interest rate risk could be the simplest- focus on short term bonds. Funds with durations of three years and less remain fairly stable when interest rates rise, and they offer a relatively safe haven during volatile times in the bond market.
A prime portfolio pick could be the Vanguard Short-Term Bond ETF (NYSE:BSV). The exchange traded fund (ETF) invests in U.S. government bonds as well as investment-grade corporate and international dollar-denominated bonds. Overall, the funds 1630 holdings creates a duration of only 2.7 years and yield of 0.61%. As rates rise, the fund should have a much easier time rolling over its portfolios into higher yielding issues. That makes it a great core option for bond investors.
A potential way to add some more oomph to that 0.61% yield could be by moving out on the credit spectrum. Strictly focusing on corporate debt could land a bigger dividend check each month. The SPDR Barclays Capital Short Term Corporate Bond (NASDAQ:SCPB) tracks investment grade bonds with an average maturity of 2 years. That focus on corporates boosts the yield to 1.53%. Additionally, going even further on the credit spectrum- down to junk status- could be even more fruitful. Featuring a similar duration, the PIMCO 0-5 Year High Yield Corporate Bond Index (NYSE:HYS) yields 5.23%.
SEE: Top 5 Bond ETFs
Senior-rate bank loans adjust rates every 30 to 90 days, making them quite attractive in rising rate environments. But because senior loans are often issued to companies with credit ratings below investment grade, they offer higher starting yields than treasuries. The sectors benchmark fund is the PowerShares Senior Loan Portfolio (NASDAQ:BKLN), which currently yields about 5%. However, the newly launched and actively managed SPDR Blackstone/GSO Senior Loan ETF (NASDAQ:SRLN) may be a better bet. Market inefficiencies exist significantly in the bond world. As such, SRLN’s active management hopes to exploit these inefficiencies are produce higher return for investors. Only time will tell, but the fund has managed to attract a significant amount of assets in a short time.
Finally, one of the best ways for investors to protect themselves against rising rates may not be in bonds at all. Dividend stocks with a history of raising payouts are especially warranted. Unlike a bond which pays a fixed rate, with stocks you could potentially get a higher dividend year after year. The Vanguard Dividend Appreciation ETF's (NYSE:VIG) index tracks a portfolio of consistent dividend growers and makes an ideal choice for playing rising rates.
The Bottom Line
As the United States moves further into recovery, it's only a matter of time before the Fed begins raising interest rates. For investors in the bond market, this could prove problematic. However, there are a few ways to help remove that interest rate risk from a portfolio. The previous picks -along with the ProShares High Yield-Interest Rate Hedged (NASDAQ:HYHG)- are great ways to stem some of the interest rate risk, while receiving great current yields as well.