With Rates on the Move, Go Shorter Duration on Corporate Bonds

Amid rising rates, fixed income investors are caught between a rock and a hard place, but one way out is to add corporate bonds with a shorter duration.

The Federal Reserve is already looking to raise rates this year, which could erode bond income over time, especially if inflation continues to run hot. Corporate bonds could be the sweet spot, giving investors an added dose of yield to counter rising rates, while also limiting the effect with a shorter duration.

“Based on Morningstar’s estimates that the US economy will grow 3.9% this year and 3.5% next year, he thinks the current sweet spot — the place where investors can get the best return in exchange for price risk — are 5-year bonds both on the government side and in corporates,” a CNN Business article says.

Investors lately have been hit from both sides, stocks and bonds. For the latter, rising yields are pushing prices down — thus, the importance of limiting duration.

“The longer the maturity, the more price movement you’re going to have,” said David Sekera, chief U.S. market strategist at Morningstar. “Maturity duration risk is the biggest risk to [bond] investors.”

Investors may have to take on more credit risk in order to get the higher yield, but Sekera also believes that corporate bonds will be stable as the economy continues to recover. That may have not been the case in 2020 when the pandemic first arrived in the U.S. and racked the bond markets.

“Between 5-year government and corporate bonds, Sekera said he thinks corporates — which pay more because they carry higher risk than Treasuries — are going to serve investors well,” the CNN article says. “That’s because he expects corporate defaults to remain low and for there to be more corporate credit upgrades than downgrades.”

Options for Shorter Duration Corporate Bonds

Vanguard has options for various durations when it comes to getting corporate bond exposure. One option is the Vanguard Short-Term Corporate Bond ETF (VCSH).

The fund seeks to track the performance of a market-weighted corporate bond index with a short-term dollar-weighted average maturity. The fund employs an indexing investment approach designed to track the performance of the Bloomberg U.S. 1-5 Year Corporate Bond Index.

This index includes U.S. dollar-denominated, investment-grade, fixed-rate, taxable securities issued by industrial, utility, and financial companies, with maturities between one and five years. Under normal circumstances, at least 80% of the fund’s assets will be invested in bonds included in the index.

For more news, information, and strategy, visit the Fixed Income Channel.