Interest rate risk doesn’t seem like much of a risk at all these days, given how low they’ve been for the last year-plus. Soon, though, rates will rise and you won’t want to get caught holding the bag.

The total value of a simple investment can be affected by rising or falling interest rates. Exchange traded funds (ETFs) can help you mitigate the risk of this happening – a benefit of their transparency. According to Investopedia, interest rate risk affects the value of bonds more directly than stocks, and it is one of the largest risks to all bondholders. [Looking For Higher Yields? Try Dividend ETFs.]

As interest rates rise, the opportunity cost of holding a bond decreases since investors are able to realize greater yields by switching to other investments more reflective of the higher rate.

Jose Garcia Zarate for Investment Week reports that the value of fixed-income holdings is exposed to changes in interest rates. Other ways that interest rates affect bond investments and ETFs:
  • Rising interest rates drive prices lower, while falling rates drive prices higher. Duration is the most commonly used measure of sensitivity of fixed income assets to changes in interest rates, expressed in number of years. The bigger the number, the greater the sensitivity to interest rate moves.
  • In a nutshell, if you expect interest rates to go up, you would be better off holding fixed-income assets with shorter durations. If you expect interest rates to fall, you would want to increase duration in order to maximize the potential for capital appreciation.
  • Consider actively managed fixed-income ETFs when seeking to manage interest rate risk. These types of ETFs adjust their exposure according to the interest rate environment, saving you the guesswork. [Can Fixed-Income ETFs Recapture Any Mojo?]
  • Watch short Treasury ETFs for clues of market sentiment, too. Funds like Direxion Daily 30-Year Treasury Bear 3x Shares (NYSEArca: TMV) and ProShares UltraShort 20+ Year Treasury (NYSEArca: TBT) can help you capitalize on any downtrend on Treasuries.

As the economy improves, the risk that the Federal Reserve will raise rates becomes greater. If you see any signs of this happening, have a strategy and be prepared to act.

Tisha Guerrero contributed to this article.

The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.