In anticipation of rising interest rates, bond exchange traded fund investors can consider a branching out across fixed-income classes to help diversify their portfolios.
While rising rates are a negative for fixed-income assets, investors should not move entirely out of bonds, writes Scott E. Couto, president of Fidelity Financial Advisor Solutions, for InvestmentNews. Alternatively, Couto suggests looking at four fixed-income classes as a way to diversify and limit rate risk.
For starters, an investment portfolio should include high-quality bonds. For instance, the iShares Credit Bond ETF (NYSEArca: CFT) and the Vanguard Total Bond Market ETF (NYSEArca: BND) provide exposure to a diversified portfolio of investment grade corporate, sovereign, local authority and non-U.S. agency bonds.
“Advisers can help investors focus on the role bonds play in a diversified portfolio – income, total return potential, and an offset to equity volatility,” Couto said in the article. “Anchoring your client’s portfolio with high-quality bonds may be an appropriate strategy. Historically, high-quality bonds have performed well when stocks have declined and typically have provided steady income.”
Investors can also venture into alternative, non-core income options in search of yields and diversify a fixed-income portfolio. Alternative strategies include high-yield, floating rate, emerging markets or real estate. The iShares iBoxx $ High Yield Corporate Bond ETF (NYSEArca: HYG) andSPDR Barclays High Yield Bond ETF (NYSEArca: JNK), are the two largest junk-bond related ETFs.
The iShares Floating Rate Bond ETF (NYSEArca: FLOT) tracks notes that have a reset period with interest rates tied to a benchmark, such as the Fed funds, LIBOR, prime rate or U.S. Treasury bill rate. The iShares J.P. Morgan USD Emerging Markets Bond ETF (NYSEArca: EMB) and PowerShares Emerging Markets Sovereign Debt Portfolio (NYSEArca: PCY) provide exposure to U.S. dollar-denominated emerging market debt. The Vanguard REIT ETF (NYSEArca: VNQ) follows real estate investment trusts, which can help diminish portfolio volatility. [Alternative Asset ETFs]
“For investors who can tolerate more risk, adding non-core income assets may offer higher income potential as well as diversification benefits such as lower sensitivity to rising rates,” Couto added.
The simplest way to hedge against rate risk is to move down the yield curve and invest in short-duration bonds. For example, the iShares 1-3 Year Treasury Bond ETF (NYSEArca: SHY), which tracks short-term Treasuries, has a duration of 1.83 years. If interest rates were to rise 1%, SHY could see its price decline by about 1.8%. In contrast, funds with longer durations would see a greater decline.
Lastly, some may want to include municipal bond exposure to diversify a portfolio. Along with attractive tax-free federal income, munis offer low correlation to stocks and other fixed-income assets. Investors can take a look at a broad muni bond ETF, like the iShares National AMT-Free Muni Bond ETF (NYSEArca: MUB) and SPDR Nuveen Barclays Municipal Bond ETF (NYSEArca: TFI). [Time to take a look at muni ETFs]
“Investing in high-quality municipal bonds may reduce credit risk and volatility,” Couto said.
For more information on the bonds market, visit our bond ETFs category.
Max Chen contributed to this article. Tom Lydon’s clients own shares of EMB, HYG and JNK.