Bond investors have enjoyed a three decade long run and yields on the benchmark 10-year Treasury note appear to be stuck below 2%.
Yet looking ahead, bond ETFs could feel serious pain if interest rates ever start rising. Yes, I know you’ve heard this before, but it doesn’t hurt to have a plan if Treasury yields begin to creep higher.
Bond prices have an inverse relationship with interest rates, writes John Waggoner for USA Today. The benchmark 10-year Treasury market has witnessed a 30-year bull rally as yields fell from the Sept. 30, 1981 peak of 15.84% – something almost unimaginable with yields currently hovering around 1.66%.
Currently, it doesn’t look like interest rates will budge anytime soon. Specifically, the Federal Reserve’s loose monetary policy has kept a lid on long-term rates, and the central bank has specifically stated that rates will remain low until unemployment drops and inflation rises.
Waggoner points out that with the German 10-year bund yielding 1.24% and the 10-year Japanese government bonds yielding 0.58%, Treasury yields may even have more room to dip lower.
Nevertheless, rates will not stay at these historically low levels forever, and once interest rates start rising, bond prices, along with bond funds, will suffer, especially those with longer maturities. [iShares: The Great Duration Rotation Continues – But For How Long?]
For most bond ETF investors, the effective duration will provide a general sense of how a fund will react to interest rate changes. For instance, if interest rates rise 1%, a fund with a duration of 4 years would be expected to fall by 4% while a 1% drop in interest rates would translate to a 4% rise in the fund’s value.
Next page: ETF options for rising rates
Consequently, investors who expect rates to rise would want to shift to bond ETFs with shorter durations. Todd Rosenbluth, director of ETF research at Standard & Poor’s Capital IQ, suggests some options, like the SPDR BarCap Short-Term High-Yield Bond ETF (NYSEArca: SJNK), which has a 2.9 year duration and a 5.9% yield, and the Vanguard Short-term Corporate Bond Index ETF (NYSEArca: BSV), which has a 2.8 year duration and a 2.1% yield.
Alternatively, investors can also consider ETFs that hold floating rate notes, which come with variable interest rates that help protect against rate changes. Investment grade floating rate ETFs, include the iShares Floating Rate Note Fund (NYSEArca: FLOT), SPDR Barclays Capital Investment Grade Floating Rate (NYSEArca: FLRN) and Market Vectors Investment Grade Floating Rate (NYSEArca: FLTR). [Bank Loan ETFs Offer 4% Yields, Protection from Rising Rates]
Additionally, SPDR Blackstone/GSO Senior Loan ETF (NYSEArca: SRLN), PowerShares Senior Loan Portfolio (NYSEArca: BKLN), and Highland/iBoxx Senior Loan ETF (NYSEArca: SNLN) provide exposure to companies that typically fall below investment-grade credit ratings, and they also come with the floating rate component. [Bank Loan ETFs: More Competition in Red-Hot Sector]
For more information on bonds, visit our bond ETFs category.
Max Chen contributed to this article.