Most investors are aware that bond exchange traded funds will likely underperform as interest rates rise. However, fixed-income investors will have to take a closer look at the yield curve to gauge their market exposure.
Since interest rates across different bonds with varying maturities don’t always move in tandem, investors need to pay attention to the yield curve to grasp the level of risk they are exposed to, according to Morningstar analyst Thomas Boccellari.
“If investors believe short-term rates will fall in the near term, the yield curve may become flat, or even inverted, where long-term interest rates are lower than short-term rates,” Boccellari said. “A flattening or inverted yield curve is often interpreted as a sign that the economy is starting to cool and that the Fed may start to lower short-term rates. In contrast, a steepening yield curve usually points to a strong economy with increased inflation expectations.”
Currently, the yield curve is considered steep due to the significant difference between long- and short-term interest rates. The bond market has been stuck in this steep yield curve due to the Fed’s decision to keep rates near zero. [A Simple Short Duration Bond ETF]
However, looking ahead, the curve could began to flatten, similar to what happened during the last increase in the federal funds rate, and may eventually invert.
The changes in the yield curve may help explain performance in bond ETFs with varying durations. Specifically, it is possible for short-term interest rates to rise while long-term rates to remain the same or even fall, reflecting a flattening yield curve. Consequently, short-term bond ETFs could see their price decline, whereas long-term bond ETFs would outperform, similar to what happened from February through September this year.
“It’s not enough to know interest rates might rise–investors must know what interest rate will move, and by how much,” Boccellari added.
Consequently, Boccellari argues that a floating-rate bond ETF may be a good fit ahead while intermediate-term bonds may be at risk.
For instance, the iShares Floating Rate Bond ETF (NYSEArca: FLOT) automatically adjust their coupons at periodic intervals in response to changes in the interest rates. FLOT essentially has an effective duration of 0.14 years.
Intermediate-term bond ETFs, like the iShares Core U.S. Aggregate Bond ETF (NYSEArca: AGG), which has an effective duration of 5.25 years, are particularly sensitive to the upcoming rate environment.
“While they have less sensitivity to interest rates than long-term bond funds, intermediate-term interest rates have historically increased more in rising interest-rate environments as the yield curve flattens,” Boccellari said.
Some investors may be tempted to dive into short-term bond ETFs for protection. However, Boccellari advises people to consider costs since fees may end up eating away at yields. For example, the SPDR Barclays 1-3 Month T-Bill (NYSEArca: BIL) shows a flat yield with a 0.13% expense ratio. [No Free Lunch with Ultra-Short-Term Bond ETFs]
For more information on the fixed-income market, visit our bond ETFs category.
Max Chen contributed to this article.