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.
The exact timing of when isn’t as important as making sure your portfolio is prepared for an impending rate regime change, one where rates are expected to rise gradually and remain low for long.
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.
If you’d like to learn more, you can find the credit spread for a given fixed income fund in the “portfolio characteristics” section of each product page—it’s called the option adjusted spread or OAS.
In rising rate environments, credit spreads tend to move in the opposite direction to interest rates and can potentially generate income to help offset some of the impact of rising U.S. Treasury yields. As such, to prepare for rising rates, you may want to seek a potentially better balance of risk and reward by focusing on credit exposure. Exchange traded funds (ETFs) focusing on credit, such as the iShares 1-3 Year Credit Bond ETF (CSJ), can potentially help you do this.
While the coming rate rise cycle is likely to be gradual, you can begin to prepare your portfolios now, and continue this preparation over the coming months.
Heidi Richardson is a Global Investment Strategist at BlackRock. She is also Head of Investment Strategy for U.S. iShares.