Stocks flailed to end the month of May and chatter is increasing that rising interest rates could put a damper on what has been an impressive rally in U.S. equities. There is evidence to support the notion that interest rates are on the upswing. On Tuesday, the yield on 10-year U.S. Treasurys hit 2.17% before moving as high as 2.23% Wednesday.
The recent move has been enough to put the yield on the 10-year Treasury note on or close to equal footing with the S&P 500 for the first time this year, William L. Watts reported for MarketWatch.
Rising interest rates have had predictable consequences this month as investors have hammered rate-sensitive sectors like REITs and utilities as Treasury yields rise on speculation the Federal Reserve is mulling an end to its asset-buying efforts. [REIT ETFs Punished By Rising Rates Trade]
It is not just previously safe dividend-paying stocks and ETFs that are vulnerable to rising rates. Long duration bonds are sensitive to higher interest rates because bonds issued at new, higher rates apply price pressure to bonds issued when rates were low. The longer a bond’s duration, the more vulnerable it is to rate changes. Reducing portfolios’ duration risk has been a popular theme this year.
“This has been a popular strategy so far this year – flows into fixed income ETFs year-to-date have been primarily into shorter duration ETFs as investors look to cut interest rate risk in their portfolios,” said iShares Head of Fixed Income Strategy Matt Tucker. “Through April 10th, $10.2 billion has been allocated to short duration ETFs while $2.8 billion has been redeemed from longer duration ETFs. Clearly investors are voting with their dollars.”
ETF investors looking for options on the shorter end of the yield curve have plenty of credible options.
Vanguard Short-Term Bond ETF (NYSEArca: BSV)
BSV tracks the arclays U.S. 1–5 Year Government/Credit Float Adjusted Index, a market-weighted bond index that covers investment-grade bonds with a dollar-weighted average maturity of 1 to 5 years. The ETF is heavily allocated to U.S. government bonds, but does feature some exposure to high-quality corporates and international issues.
Credit risk is minimal as all of BSV’s holdings are rated Baa or higher. Investors will find at least two things to like about BSV. First, the ETF’s 0.1% annual expense ratio makes it cheaper than 88% of equivalent funds. Second, its average duration is just 2.7 years, according to Vanguard data.
PIMCO 0-5 Year High Yield Corporate Bond Index ETF (NYSEArca: HYS)
A move to shorter duration fare does not always have to mean a significant sacrifice in yield. Actively managed HYS proves as much with a 30-day SEC yield of 2.83%. High-yield corporate bond ETFs with shorter durations provide a nice balance for investors that want yield, but are also concerned about rising rates. [Two High Yield Bond ETFs For Rising Rates]
HYS is not yet two years old and already has $2.2 billion in assets. Home to 335 holdings, HYS has an effective duration of just 1.87 years.
PIMCO 0-5 Year High Yield Corporate Bond Index ETF
ETF Trends editorial team contributed to this piece.
Full disclosure: Tom Lydon’s clients own BSV.