As yields increase, short-maturity bond funds can offer both higher income potential and a cushion against interest rate risk. Karen explains the mechanics, in part three of her Rising Rates series.
One of the ways to navigate a rising rate environment is to reduce your exposure to bonds with greater levels of interest rate risk. For many investors, this means moving toward short-maturity bonds. In exchange for lower risk, these issues typically generate lower income than longer-maturity bonds.
The current market environment is unusual, however. A flatter yield curve means that short bonds are providing similar income to their longer-maturity counterparts–while still reducing interest rate risk.
Investors wanting to gain exposure to short-maturity bonds often do so through bond exchange traded funds (ETFs) or mutual funds, which typically hold a diversified portfolio of bonds with maturities less than five years.
Perpetual bond ladder
Fixed-rate short-maturity bond funds tend to act like a perpetual bond ladder, especially if the fund is an index fund with a defined maturity range, such as 1- to 3-year or 1- to 5-year. The fund’s portfolio manager rebalances the fund monthly, removing bonds at the low end of the maturity range and adding ones at the higher end. Over time, the portfolio adjusts to the new yield environment; as yields rise, the income increases on the portfolio.
Bond income can help offset price shocks
The U.S. Federal Reserve has ended its zero interest-rate policy. It hiked its Fed Funds target rate seven times since December 2015, from 0%-0.25% to 1.75%-2.00% by June 2018. These rate increases are good news for savers as they are getting more yield on their savings. While prices on bonds have fallen over that time, rising yields have in certain cases offset those losses. (Bond prices and yields move in opposite directions.)
Too often, investors focus on the price return and forget about the INCOME portion of return in fixed income. The chart below shows the performance of various short-maturity bond indexes, which were analyzed to see how much of the total return came from bond price changes and how much came from income as rates rose.
Note that ultra-short bonds, represented by 1- to 12-month US Treasury bills (T-bills), had very little price movement while increasing the income contribution over this time period. Fixed-rate short-maturity sectors like U.S. Treasuries and credit with 1-3 years to maturity both had prices losses, but increased their income as rates went up. The clear winner over this period was floating rate notes, which had positive returns for both price and income.
Index performance is for illustrative purposes only. Index performance does not reflect any management fees, transaction costs or expenses. Indexes are un-managed and one cannot invest directly in an index. Past performance does not guarantee future results.
Match maturities to objectives
The choice between ultra-short, short-term or floating rate bonds depends on your holding period and investment objectives. For a very short-term holding period, consider sticking to high-quality ultra-short maturities, such as less than one year. If you have a longer holding period (over 12 months), short-maturity fixed-rate bond ETFs can provide more income potential during rising rate periods if you can tolerate the price changes over the period.
Exchange traded funds like iShares Short Treasury Bond ETF (SHV), iShares 1-3 Year Treasury Bond ETF (SHY) and iShares Short-term Corporate Bond ETF (IGSB) can provide investment options for those looking for exposure to short-maturity bonds.
Karen Schenone, CFA, is a Fixed Income Product Strategist within BlackRock’s Global Fixed Income Group and a regular contributor to The Blog.
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