Rising interest rates is a reality that many investors will be forced to contend with over the next several years. While the timing of the Federal Reserve’s monetary policy tightening schedule is difficult to discern, there is noticeable angst in the bond market that is already triggering above-average volatility in fixed-income.
Bonds are supposed to be one of the safest places to invest your money. Investors that implement a diversified portfolio use them as shock absorbers to help smooth out the ups and downs of their stock positions. In addition, they can be helpful for retired investors to generate a consistent income stream or transition to a more conservative asset allocation.
However, choosing the right type of bond fund for your risk tolerance can make all the difference in the world.
Remember that bond yields and bond prices move inverse to each other. As a result, bond funds with higher credit quality holdings and longer average durations will be more susceptible to incremental changes in U.S. bond yields.
The benchmark for most U.S. focused bond funds is the iShares Core U.S. Aggregate Bond ETF (AGG). This exchange-traded fund follows the well-known Barclays U.S. Aggregate Bond Index, which is a conglomeration of Treasury, government, mortgage, and corporate debt. AGG has an effective duration of 5.29 years, which is derived from the underlying holdings responsiveness to interest rate changes.
A fund like AGG make sense to own during a falling interest rate environment because of its wide diversification and quality-focused holdings. However, this same strategy will drastically underperform during a cyclical period of rising rates.
For some investors, it may make sense to consider moving a portion of your portfolio to bond funds with less sensitivity to interest rate fluctuations. The tradeoff is that you will receive a lower yield on your invested capital. However, that may be worth the benefit of experiencing much lower overall price fluctuations in your account …allow you to sleep better at night.
One option to consider is the Vanguard Short-Term Bond ETF (BSV), which is the fourth largest bond ETF by size with over $17 billion in assets. BSV invests in quality U.S. bonds with maturities in the 1 to 5-year spectrum and charges an expense ratio of just 0.10%. The current yield of this ETF is 1.13%, which is far less than the 2.02% yield of AGG. Nevertheless, the lower effective duration of BSV will ensure that peaks and valleys in price will be minimized relative to the more aggressive benchmark.
Another alternative is the iShares 1-3 Year Credit Bond ETF (CSJ). This ETF takes a slightly different approach by focusing on investment grade corporate, government, and supranational bonds. CSJ has an effective duration of just 1.93 years and a current yield of 1.34%. A fund of this nature may be used as a more conservative alternative to traditional corporate bond funds that are heavily tied to the health of the credit markets.
Lastly, for those seeking a tax-free low volatility bond ETF, the iShares Short-Term National AMT-Free Muni Bond (SUB) may work in your favor. SUB invests in a broad array of short-dated municipal bonds throughout the country. It currently has a yield of 0.48% and an effective duration of 2 years. While the yield on SUB may seem paltry, on a tax-equivalent basis, it becomes comparable to many of its peers. This type of ETF may be appropriate for those looking for a modest return on taxable assets with less volatility than conventional municipal bond funds.
Many investors have made up their minds to abandon fixed-income altogether as the interest rate landscape begins to change. However, in my opinion, this asset class will still play an important role in portfolio diversification and keeping your risk appetite in check. Having some of these low volatility tools in your arsenal may help guide the way forward for those that still need income and balance in their investment accounts.
Until next time,
David Fabian is a Managing Partner at FMD Capital Management, a fee-only registered investment advisory firm specializing in exchange-traded funds. He has years of experience constructing actively managed growth and income portfolios using ETFs. David regularly contributes his views on wealth management in his company blog, podcasts, and special reports. Visit www.fmdcapital.com to learn more.