For the first time in three decades, investors are beginning to realize the potential detrimental effects rising rates will have on a fixed-income investment portfolio. Nevertheless, exchange traded fund investors can take steps to obviate the damage.
When it comes to bonds, investors have enjoyed seeing their investments generate higher returns as rates fall. However, as interest rates begin to rise off a 30-year low, bond prices are declining.
On the other hand, some investors would rather hold onto the bond investment and wait until maturity. Nevertheless, many bonds pay less than the current inflation rate, which generates an automatic loss. Additionally, once inflation begins to accelerate - it is currently below the Fed's 2% target, an investor's purchasing power diminishes and the money returned on the bond will be lowered.
Mitch Tuchman for Forbes points out a couple ways to spread out bond risk:
- Bond duration. Duration is the measure of a bond security's sensitivity to changes in interest rates. Bonds with longer durations will experience greater losses during periods of rising rates. Consequently, Treasury investors may want to ease of long-term 20+ year bonds. Instead, consider a Treasury ETFs with shorter durations, such as the iShares 7-10 Year Treasury Bond ETF (NYSEARCA:IEF), which has a 7.44 year duration.
- Speculative-grade debt. Junk bonds generate higher yields to compensate for their lower credit ratings. The SPDR Barclays Short-Term High-Yield Bond ETF (NYSEARCA:SJNK) has a 2.26 year duration and a 4.51% 30-day SEC yield.
- International debt. Investors are typically overweight to the U.S. and should include some foreign holdings. The Fed may be planning on raising rates in the near future, but other central banks are moving on their own schedules. For instance, the SPDR Barclays Capital International Treasury Bond ETF (NYSEARCA:BWX) offers investment-grade debt from many countries outside the U.S. BWX has a 7.08 year duration and a 1.68% 30-day SEC yield.
- Other income investments. Dividend stock ETFs also offer a steady income stream. The Vanguard Dividend Appreciation ETF (NYSEARCA:VIG) tracks high quality companies with a record of increasing dividends for at least 10 years. VIG has a 2.09% 12-month yield.
- Rebalance regularly. Investors should get in the habit of rebalancing their investment portfolios or at least take a look at holdings. Financial advisors typically sell high and buy low with a predetermined discipline as a way to protect portfolios from unnecessary risks.
Max Chen contributed to this article.
Full disclosure: Tom Lydon's clients own BWX.
Disclosure: I am long BWX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.