It has been nearly 10 years since the Federal Reserve (Fed) last raised interest rates, and though the central bank didn’t hike rates this month, higher rates look to be coming.
How can you do this? I’ve already covered some potential opportunities to look for in stocks. When it comes to the fixed income portion of your portfolio, you may want to consider these two strategies.
Two Ways to Prepare Your Bond Portfolio
1. Know where to hold your duration
Duration is a metric that helps us understand how bond prices change in reaction to interest rate moves. Think of it as a measure of a bond’s sensitivity to interest rates. When interest rates change, a bond’s price will change in the opposite direction of rates by a corresponding amount. For example, if a bond’s duration is five years and interest rates rise one percent, you can expect the bond’s price to fall by approximately five percent.
Shortening the duration of your bond portfolio can potentially help manage losses due to rising interest rates. Therefore, if you are concerned about price losses on bonds, you may want to invest in bonds with lower durations. Low duration can mean less volatility or price risk.
While shortening duration can help mitigate interest rate risk, another approach to consider is one that balances exposure to the very front end of the curve with exposure to intermediate maturities for additional yield potential and lower volatility, given that rates are likely to rise slowly and stay historically low for the foreseeable future. Exchange traded funds (ETFs), such as the iShares Floating Rate Bond ETF (FLOT) and the iShares Short Maturity Bond ETF (NEAR), can help you shorten your duration.
2. Focus on credit
When you invest in credit, you are typically compensated for taking more risk via a higher yield. This additional yield on a riskier credit bond is called the credit spread, and it’s measured against a similar duration U.S. Treasury bond.