With many anticipating the Federal Reserve will begin raising interest rates ahead, fixed-income investors can go down the yield curve to lower duration bond exchange trade funds to diminish rate risks.
“We see opportunities in short-term U.S. credit,” BlackRock strategists said in a note. “Money market reforms due in mid-October have pushed up yields of short-end corporate and municipal bonds, and we see short-term paper offering some protection from any jump in long-term rates. U.S. investment grade corporate debt remains attractive in a yield-hungry world, in our view.”
In a rising rate environment, the price of older bonds with lower rates will fall since these older debt securities appear less attractive and traders would demand a discount on the older lower-yielding debt. On the other hand, new bonds are issued at the newer and higher rates, so investors would be less inclined to hold older debt securities with less attractive yields. As a result, the less appealing older bonds will see prices fall in response to the diminished demand.
Bond funds hold a collection of debt with varying maturities, buying and selling debt securities to maintain their short-, intermediate- or long-term strategy. When it comes to bond ETFs, investors should look at the duration, or a bond fund’s measure of sensitivity to gauge their investment’s exposure to changes in interest rates – a higher duration means a higher sensitivity to shifts in rates.
Consequently, if interest rates rise, shorter term bond funds may show limited sensitivity to the changes, whereas bond funds with longer durations could take a beating.