Many investors are preparing for an eventual interest rate rise by decreasing duration, or interest rate risk, in their bond portfolios. Matt Tucker gives four ways to employ the strategy using ETFs.
Last week, the Fed once again announced that it will refrain from tapering its bond-buying program until it sees more evidence that the economy is improving.
While this statement was less of a surprise than the Committee’s September announcement, as usual it will incite a lot of speculation about the expected timing of a taper. But whether you believe it will occur in two months or twelve, the bottom line is that quantitative easing will eventually come to an end and, subsequently, interest rates will rise.
Investors widely acknowledge this fact, which is why for the past year we’ve seen a huge shift in bond ETF flows from intermediate and long duration funds to short duration funds. Longer duration bonds generally offer more yield, but they’re also subject to greater price declines when interest rates rise. Because of this, investors that fear a rate rise often shorten the duration of their bond portfolios, believing that the yield they give up will be more than compensated for by avoiding a price loss with longer duration bonds.
ETFs are a great way to execute this strategy. Because of the wide variety of bond ETFs out there, it’s easy to customize your short duration bond exposure using just one or two funds.
So how do you choose the right short duration bond ETF for your portfolio? It all depends on your investment goals:
|If your goal is . . .
||Try a . . .
||Potential iShares solutions
||Multi-sector ETF to help lower interest rate risk but maintain exposure to a range of asset classes.
||iShares Short Maturity Bond ETF (NEAR)iShares Core Short-Term U.S. Bond ETF (ISTB)
||U.S. Treasury ETF to seek both reduced interest rate risk and the safety of Treasury bonds.
||iShares Short Treasury ETF (SHV)iShares 1-3 Year Treasury Bond ETF (SHY)
||Credit ETF to help reduce interest rate risk but still have potential for yield by investing in corporate bonds that carry credit risk.
||iShares Floating Rate Note ETF (FLOT)iShares 1-3 Year Credit Bond ETF (CSJ)iShares 0-5 Year Investment Grade Corporate Bond ETF (SLQD)iShares 0-5 Year High Yield Bond ETF (SHYG)
|Declining maturity over time
||Term maturity ETF if you have a specific time horizon for your investment, or you want a fund that matures on a specified date and has a final distribution like individual bonds.
||iSharesBonds 2016 Corporate Term ETF (IBDA)iSharesBonds 2016 ex-Financials Term ETF (IBCB)
And if you’re wondering how these exposures compare when it comes to yield (measured by average yield to maturity) and duration, check out the chart below*:
You can’t control when interest rates will rise, but you can prepare your portfolio for that eventuality. Luckily, ETFs make that task a bit easier by allowing investors to employ strategies like reducing portfolio duration in an efficient and customized way.
Matt Tucker, CFA, is the iShares Head of Fixed Income Strategy and a regular contributor to The Blog. You can find more of his posts here.
*Source: BlackRock as of 10/18/13
The performance quoted represents past performance and does not guarantee future results. Investment return and principal value of an investment will fluctuate so that an investor’s shares, when sold or redeemed, may be worth more or less than the original cost. Current performance may be lower or higher than the performance quoted. Performance data current to the most recent month end may be obtained by calling toll-free 1-800-iShares (1-800-474-2737) or by visiting www.iShares.com. For standardized performance for the funds discussed, please click here. For the SEC 30-day yield for these funds, please click here and click the “Fundamentals” tab.
This information must be preceded or accompanied by a prospectus. For a current prospectus, please click on the “Prospectuses” link below.
Bonds and bond funds will decrease in value as interest rates rise and are subject to credit risk, which refers to the possibility that the debt issuers may not be able to make principal and interest payments or may have their debt downgraded by ratings agencies. High yield securities may be more volatile, be subject to greater levels of credit or default risk, and may be less liquid and more difficult to sell at an advantageous time or price to value than higher-rated securities of similar maturity. Securities with floating or variable interest rates may decline in value if their coupon rates do not keep pace with comparable market interest rates. The iShares Floating Rate Note ETF’s income may decline when interest rates fall because most of the debt instruments held by the Fund will have floating or variable rates. An investment in the Fund(s) is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency.
The iSharesBondsTM ETFs (“Funds”) will terminate on or about March 31 of the year in each Fund’s name. An investment in the Fund(s) is not guaranteed, and an investor may experience losses and/or tax consequences, including near or at the termination date. In the final months of each Fund’s operation, its portfolio will transition to cash and cash-like instruments. As a result, its yield will tend to move toward prevailing money market rates, and may be lower than the yields of the bonds previously held by the Fund and lower than prevailing yields in the bond market.
The iShares Short Maturity Bond ETF is an actively managed ETF that does not seek to replicate the performance of a specified index. The Fund may have a higher degree of portfolio turnover than funds that seek to replicate the performance of an index. The iShares Short Maturity Bond ETF will invest in privately issued securities that have not been registered under the Securities Act of 1933 and as a result are subject to legal restrictions on resale. Privately issued securities are not traded on established markets and may be illiquid, difficult to value and subject to wide fluctuations in value. Delay or difficulty in selling such securities may result in a loss to the iShares Short Maturity Bond ETF. Fund may invest in Asset-backed (“ABS”) and mortgage-backed securities (“MBS”) which are subject to credit, prepayment and extension risk, and react differently to changes in interest rates than other bonds. Small movements in interest rates may quickly reduce the value of certain ABS and MBS.