Another sector to rotate into might be even higher risk asset classes that would also benefit from spread tightening, such as emerging market debt, for example the iShares Emerging Markets Bond ETF (EMB). Layering in ETFs in these asset classes can help offset price losses from rising risk-free interest rates as more of their yield comes from the credit spread. However, be aware that you are trading off interest rate risk for credit risk within a portfolio by employing these strategies. A deterioration in the economy and the credit market could adversely impact such a portfolio.
Hopefully this has post has provided more clarity on how to think about asset allocation in a rising interest rate environment. In my next post, I will illustrate how to use ETFs to reduce interest rate risk when rates increase.
Market Realist – The graph above shows the total returns of the iShares JPMorgan USD Emerging Market Bond ETF (EMB) and iShares Barclays 7-10 Year Treasury Bond ETF (IEF). Emerging market bonds have outperformed Treasuries with returns of 21.4% versus the 16.1% of Treasuries over the last four years. This translates to annual returns of 5.0% and 3.8%, respectively.
An improvement in the credit market would lead to spread compression. However, we advise caution while investing in emerging markets (EEM)(VWO). Emerging market bonds tend to be riskier than developed market (EFA) bonds.
Please read Market Realist’s Why you should ready your equity portfolio for rising rates to learn key strategies.