As the economy imploded back in 2008/2009, the Federal Reserve did everything it could to reignite growth. That included sending short term interest rates down to the basement for the last five years or so. In order 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 20+ Year Treasury Bond (TLT).
That’s kind of a big problem.
With the central bank now tapering its quantitative easing programs and new Fed chairwomen Janet Yellen hinting that a bump upwards in short term rates could be near, longer-dated bond holders are in for a world of hurt. Luckily, there are ways to shorten your duration and prevent some of the potential losses when interest rates rise.
Going Short Is Key
Giving her first testimony as the head of the Fed, Janet Yellen gave investors a bit of a surprise- higher interest rates could be around the corner and much sooner than many analysts had predicted. Overall, Yellen predicts the Fed could do an initial rate increase as early as spring of 2015, as the economy improves. That statement was echoed by several other Fed board members. Many investors had pegged that a rate increase wouldn’t come until 2016 at the earliest.
While that increase to short-term interest rates is actually a good thing- meaning the 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. That essentially means as interest rates rise, bond prices will fall.
And for those investors looking at long-dated bonds, that fall is going to be felt even harder.
That’s because a bond’s duration is a key factor in determining its gains and losses. Duration is a way to measure a bond’s price sensitivity to interest-rate movements. The longer the duration, the worse the drop. For example, if interest rates were to rise by 1%, a bond fund- like the uber-popular Vanguard Total Bond Market ETF (BND) and its average duration of 10 years- would see its price fall by about 10%. Meanwhile, a similar investment with a one-year duration might only decline only 1%.
And given that the Federal Reserve is going to be raising rates very soon, investors holding long-duration bonds are going to get killed. The sheer thought of rising interest rates sent the Barclay's 10-30 Year Treasury Index- with a duration of about 16 years- down about 13% last year.
Investors who hold positions in “core” bonds funds like the iShares Core Total US Bond Market ETF (AGG) should think about lightening up their duration exposure by adding a swath of short duration bonds. There are plenty of ways to do just that courtesy of the ETF boom.
For those looking for the safety and high credit quality of Treasury Bonds, the Schwab Short-Term US Treasury ETF (SCHO) could be a prime place to start. The ETF tracks 49 treasury bonds and its underlying index has a low duration of only 1.9 years. That will help it survive as interest rates rise. Also helping the fund is its low expense ratio of only 0.08%. That helps SCHO provide a little extra yield versus rival funds like the PIMCO 1-3 Year US Treasury Index ETF (TUZ). Albeit, yields are still pretty paltry.
For investors still looking for more income, short term corporate bonds could be the answer. Schwab and Vanguard’s commitment to low cost funds makes them top buys in their respective sectors. The Vanguard Short-Term Corporate Bond ETF (VCSH) holds over 1,600 corporate bonds, including New York-based companies like telecom giant Verizon (VZ) and investment bank Citigroup (C). That breadth of holdings, along with a low duration of 2.8, makes it a prime corporate bond play. Likewise, the SPDR BarCap ST High Yield Bond ETF (SJNK) can be used to bet on corporate issuers with less than stellar credit ratings.
Finally, for those investors looking to hide out in cash as rates rise, the actively managed ETF duo iShares Short Maturity Bond (NEAR) and PIMCO Enhanced Short Maturity ETF (MINT) make ideal plays. Both hold a mixture of emerging and developed market government, corporate and mortgage-related short-term investment-grade debt. Both funds should be able to capture rising interest quicker as their durations are both less than a year.
The Bottom Line
While the specter of rising interest rates has been haunting the markets for years now, it seems that fear is finally coming true. The recent Fed tapering agenda, along with comments made by key central bank officials, both indicate that interest may be heading higher sooner rather than later. Given that scenario, the time for bond investors to get short is now. The previous picks- along with funds like the Guggenheim Enhanced Short Duration ETF (GSY) –make ideal selections to shorten up their duration exposure.
Disclaimer - At the time of writing, the author did not own shares of any company mentioned in this article.