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Tickers in this Article: BSV, TLT, IEF
Inflation concerns have cooled off temporarily and talk of deflation has begun to emerge. Now that the Federal Funds rate has been cut down to 1% and oil prices are in the $50 price range, investors should consider how a resurgence of higher interest rates and inflation could affect their portfolios. The following briefly reviews how investors can use bond ETFs with short- and long-term maturities for protection. (To learn more, read Bond ETFs: A Viable Alternative.)

Interest Rate Basics
Interest rates typically have an inverse relationship with bond prices. As interest rates go up, bond prices go down. You can see this represented in the recent performance of the bond ETFs in the table below. Falling interest give rise to fixed-income investments with long-term maturities like the iShares Lehman 20+ Year Treasury Bond (NYSEArca:TLT). Conversely when interest rates are rising during periods of inflation, investments with long-term maturities tend to underperform investments with shorter terms to maturity like the Vanguard Short-Term Bond ETF (NYSEArca:BSV).

Fixed Income ETF
Year to Date
(Nov. 21, 2008)

iShares Lehman 20+ Year Treasury Bond (NYSEArca:TLT)
14.72%
iShares Lehman 7-10 Year Treasury Bond (NYSEArca:IEF)
10.37%
Vanguard Short-Term
Bond ETF
(NYSEArca:BSV)

4.31%

Recent History
The Federal Reserve cut the federal funds rate down to 4.50% in November 2007. One year later additional cuts have pushed the Federal Funds rate down to 1.00%. In response to falling interest rates, the iShares Lehman 20+ Year Treasury Bond has out performed its peers with shorter maturity periods since the beginning of the year through November 21. However, investors hoping to chase the performance of the 20+ Year Treasury Bond fund should consider the unknown future direction of interest rates.

Interest Rate Volatility
The Federal Reserve could decide to cut interest rates below the current 1.0%. In 1999, Japan's Central Bank cut its interest rate to 0% in an attempt to bolster the country's faltering economy. The rate cut in Japan did not have an immediate positive effect on the economy.

While investments with long-term maturities may continue to lead their peers, in this scenario investors should also consider short-term alternatives in order to prepare for interest rates to eventually move in the opposite direction. The Federal Reserve has not made a clear decision on which way it will go, but it is clear that the Fed is willing to make changes as necessary.

Final Thoughts
The best way to overcome not knowing the future is to focus more on diversification and less on recent performance. A balance of long, medium and short term fixed income ETF investments is likely the best protection investors can get. Investors will benefit from the income generated from the investment's dividend yields and avoid the stress of misjudging the unpredictable future of interest rates.

For added insight, check out How To Use ETFs In Your Portfolio.

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