The billions in stimulus cash that has been unleashed upon the world has the potential to result in inflation and rising interest rates. While you can’t control inflation or when and by how much interest rates rise, you can certainly control the impact these events have on your clients’ portfolios.
A changing interest rate environment could alter your way of investing in exchange traded funds (ETFs), and thankfully, ETFs make it easy to put defensive strategies to use.
Experts vary in their prognostications about when the interest rate hikes will occur. All indications from the Federal Reserve are that this won’t happen for quite some time. The economic recovery is still proceeding at too slow a pace, and Chairman Ben Bernanke has pledged to keep rates where they are as long as this is the case.
Just because it hasn’t happened yet, however, doesn’t mean it won’t. Advisors need to be on alert for changes and ready to implement an appropriate strategy into their clients’ portfolios for the best protection.
Treasury Inflation-Protected Securities (TIPS)
TIPS are directly linked to the Consumer Price Index (CPI), which makes it a natural choice for those concerned about inflation. The principal on TIPS adjusts along with changes in the CPI. Although, investors will sacrifice some yield for the added benefit of this strategy.
The price of TIPS generally responds more to inflation expectations than the actual rate of inflation. They have the same credit risk as Treasury bonds (that is, almost none). How they work is that if you buy $100 and the rate of inflation is 2% for 10 years, the principal will grow at that rate each year.
Investors have been pouring into these ETFs lately – iShares Barclays TIPS (NYSEArca: TIP) took in nearly 25% of its $20 billion in assets in 2009 alone, even though inflation isn’t here yet. The risk in buying too early is that if inflation doesn’t occur, you’re stuck with a lower yield. And if deflation happens, it will cut into your yield. Use caution with TIPS and know when to buy and have a plan to sell, too.
When inflation does arrive, here are some other TIPS funds, all of which can be found on our ETF Analyzer, that can help you hedge it:
- PIMCO 1-5 Year U.S. TIPS (NYSEArca: STPZ)
- SPDR Barclays Capital TIPS (NYSEArca: IPE)
- PIMCO 15+ Year U.S. TIPS (NYSEArca: LTPZ)
- PIMCO Broad U.S. TIPS (NYSEArca: TIPZ)
- iShares Barclays TIPS (NYSEArca: TIP)
As rates rise, it’s the longer-term bonds that tend to get hit the hardest, bringing prices down and sending yields up. This is why short-term bonds will become more advantageous in a rising rate environment, making them one of the most obvious picks for advisors looking to hedge against rising interest rates.
Advisors who do make the switch over to short-term bond funds in anticipation of rising rates usually stick to one- to three-year durations, but they may miss out on the benefits of ultra-short bond funds that target shorter durations, usually between half and one-half years. You can find out what these ETFs are yielding by adding the yield as a criteria in the ETF Analyzer.
A few short-duration bond funds include:
- iShares Barclays 1-3 Year Treasury Bond (NYSEArca: SHY)
- iShares Barclays Short Treasury Bond (NYSEArca: SHV)
- PIMCO 1-3 Year U.S. Treasury Index (NYSEArca: TUZ)
As inflation becomes a factor, our purchasing power could erode as the dollar becomes weaker. Higher borrowing costs could also chip away at this. One way to hedge this is via international sovereign debt. In light of the crisis in Europe, some of these funds can be appealing for those willing to take on the risk and some even have attractive yields. Emerging market bond funds, for example, are yielding around 6%. But not all countries are in bad shape, and some of these ETFs have exposure to the more fiscally prudent ones.