The Federal Reserve has not raised interest rates this year and fixed income traders see little chance of higher rates following the Fed’s April meeting. In fact, the overwhelming feeling in the bond market is that the Fed is likely to raise interest rates just twice this year, down from expectations of at least four interest rate hikes heading into 2016.
Though interest rate increases, if they arrive at all this year, are likely to be small and easy to digest, that does not mean investors should pass up on adding on some lower duration fare to their portfolios in case the erratic Fed quickly changes policy. Investors can accomplish that objective with exchange traded funds such as the Vanguard Short-Term Corporate Bond Index Fund (NYSEArca: VCSH).
The yield and bond’s price have an inverse relationship, so bond funds with long durations would experience large price drops if rates were to rise. In contrast, short-duration bond funds will experience more muted volatility in case of sudden rate changes.
Due to their weighting methodology, aggregate bond exchange traded funds have increasingly accumulated a larger tilt toward U.S. Treasuries. As rates begin to rise, ETFs with heavier positions in higher duration Treasury bonds could begin to lag other fund strategies.
Aggregate bond ETFs, or funds with broad bond exposure, are weighted by market capitalization, so issuers with the largest amount of cumulative debt outstanding have a larger weight in the index. That could make broad bond ETFs vulnerable to interest rate hikes, but an ETF like VCSH with a shorter duration and corporate focus can be durable even amid several rate hikes.