How interest rates affect yield
The Fed funds rate has been the range of 0% to 0.25% for some time now—its lowest ever. Pursuant to the recent FOMC meeting in March, members of the Fed, including Chairwoman Janet Yellen, have indicated that the Fed will likely maintain the current target range for the Federal funds rate well past the time that the unemployment rate declines below 6.5%, especially if projected inflation continues to run below the Committee’s 2% longer-run goal. Until then, we can expect the Fed funds rate to stay at the zero lower bound.
So investors need to understand the risk in their investments that would exist when interest rates begin to rise.
Most fixed-income investments are sensitive to changes in interest rates. Interest rates and bond prices share an inverse relationship. When rates rise, bond prices tend to fall. A fall in bond prices gives an upward push to yields, as yield = coupon rate / market price. As market prices decrease, the yield on a bond goes up.
While changes in interest rates may not prompt long-term value investors in the equities of safe companies like Apple Inc. (AAPL) and Exxon Mobil (XOM) to react, investors in high-duration bonds and bond ETFs may want to shift their investments to shorter-duration bonds and bond ETFs. The iShares Barclays 1-3 Year Treasury Bond Fund (SHY) and the SPDR Barclays Capital Short Term High Yield Bond Fund (SJNK) are popular ETFs with shorter average duration. The Vanguard Short-Term Corporate Bond ETF (VCSH) is another popular ETF with an average duration of 2.9.
Strategy for rising rates: Shorten duration
However, during an interest rate rise, certain bonds and bond funds fare better than others. The key is to choose the right investment so as to negate the notional loss of rising interest rates. Shorter-duration ETFs, being less sensitive to interest rate changes, are preferable over long-duration ETFs in these times. Investors often move assets in fixed-income portfolios on expectations of rising interest rates, shifting to shorter-duration bond exchange-traded funds (or ETFs).
Choosing bonds or bond funds with shorter durations can help mitigate the effect of rising rates. These bonds typically pay less than longer-term bonds—so their low yields may not be right for investors with longer timeframes. But these bonds do mature more quickly, allowing the investor or the ETF fund manager to put that cash into higher-paying bonds sooner, helping manage one of the challenges of rising rates.
To learn more about investing in fixed income securities, check out Market Realist’s Fixed Income ETFs page.