Last week, the Fed once again announced that it will refrain from tapering its bond-buying program until it sees more evidence that the economy is improving.
While this statement was less of a surprise than the Committee’s September announcement, as usual it will incite a lot of speculation about the expected timing of a taper. But whether you believe it will occur in two months or twelve, the bottom line is that quantitative easing will eventually come to an end and, subsequently, interest rates will rise.
Investors widely acknowledge this fact, which is why for the past year we’ve seen a huge shift in bond ETF flows from intermediate and long duration funds to short duration funds (link to latest flows post). Longer duration bonds generally offer more yield, but they’re also subject to greater price declines when interest rates rise. Because of this, investors that fear a rate rise often shorten the duration of their bond portfolios, believing that the yield they give up will be more than compensated for by avoiding a price loss with longer duration bonds.
ETFs are a great way to execute this strategy. Because of the wide variety of bond ETFs out there, it’s easy to customize your short duration bond exposure using just one or two funds.