9 Bond ETFs That Will Do Well When Interest Rates Rise

A client called me today because he heard that bonds were going to get crushed and noticed that he had 40% fixed income in his portfolio.  “Get rid of all of these bonds in my portfolio”, was his next request.  I get this request often, as you can’t read or listen to financial news without hearing how interest rates will continue to move higher, which means that bond prices will be going down.  Now, I’m not in the “bond prices are going to get crushed” camp, but I can understand the reason that people are nervous.  The world economy is improving, and inflation should be increasing which should force the world’s central banks to go from printing money, to raising interest rates.  Still, a retiree can’t risk his retirement by putting all of his money into the stock market, as bonds do help smooth out stock market volatility.  This post gives you some ideas how you can invest in bonds without putting your portfolio at risk if interest rates rise.  

A quick note on the investment options below.  Duration is the measure of interest rate sensitivity of a bond.  The lower the duration, the less the interest rate sensitivity of the bond fund.  For example, a duration of 3 indicates that the bond fund should decrease by 3% if interest rates go up by 1%, and vice versa.  

Floating Rate Bonds

Floating rate bonds interest rates reset every 90 or 120 days.  Which means if interest rates rise, you will receive more interest from your floating rate bond.  Floating rate bond prices actually perform better when short-term interest rates rise.  If interest rates rise, especially if the economy remains strong, floating rate bonds should do very well.  Floating rate bonds do come with their risks.  Floaters tend to be issued by lower credit quality companies, and don’t do as well as traditional bonds when interest rates and the stock market moves lower.  

iShares Floating Rate ETF VanEck Vectors Investment Grade Floating Rate ETF SPDR Barclay’s Capital Investment Grade Floating Rate ETF
Ticker FLOT FLTR FLRN
Expense Ratio 0.20% 0.14% 0.15%
Duration 0.14 0.13
Current Yield 1.45% 1.68% 1.63%
Standard Deviation 0.36 0.59 0.35
1-year return 1.91% 2.38% 1.94%
3-year return 1.30% 1.70% 1.41%
5-year return 0.95% 1.30% 0.87%

Source :  Morningstar 2.12.18

High Yield Bonds

I call them high yield bonds but they are also referred to as junk bonds. As you may have guessed, these aren’t the highest quality bonds out there but they have a place in a portfolio. If the economy remains strong, high yield bonds should do very well. High yield bonds perform well when the company that issues the bond is healthy. If the market and economy were to struggle, these bonds would also suffer.

iShares iBoxx $ High Yield Corporate Bond SPDR Bloomberg Barclays High Yield Bond PowerShares Senior Loan ETF
Ticker HYG JNK BKLN
Expense Ratio 0.49% 0.40% 0.65%
Duration 5.93 3.75
Current Yield 5.12% 5.59% 4.14%
Standard Deviation 5.41 6.00 2.93
1-year return 2.79% 2.86% 2.82%
3-year return 3.32% 2.93% 2.67%
5-year return 3.82% 3.49% 2.52%

Source :  Morningstar 2.12.18

Mortgage Backed Securities

Mortgage Backed Securities (MBS) are bonds backed by a collection of mortgages.  No, I’m not talking about the subprime mortgage loans from the movie the “Big Short”. MBSs tend to do well when the economy is humming and people are able to pay back their mortgage.  The biggest risk to MBSs are lowering interest rates.  The problem with lowering interest rates on a MBS is that people will refinance their home and the loan will be repaid early and new loans will be at a lower interest rate.  As a result, a MBS will yield less in interest and will become less valuable.  When interest rates rise, and people are not refinancing their loans and new loans are at higher interest rates, MBSs will be more attractive than traditional bonds.  Mortgage Backed Securities tend to be less interest rate sensitive than traditional bonds.  Therefore, when interest rates are moving higher, MBSs tend to do better than traditional loans, and when interest rates are going down, MBSs tend to do worse.  

 

iShares MBS Bond ETF Vanguard Mortgage Backed Securities ETF First Trust Low Duration Mortgage Opportunities ETF
Ticker MBB VMBS LMBS
Expense Ratio 0.09% 0.07% 0.67%
Duration 4.65 4.32
Current Yield 2.25% 2.19% 2.74%
Standard Deviation 1.94 1.90 1.15
1-year return 0.15% 0.05% 1.37%
3-year return 0.79% 0.91% 3.48%
5-year return 1.50% 1.64%

Source :  Morningstar 2.12.18

Stable Value Funds

I wrote an article about reasons why you should hold onto your 401(k) even after retirement.  One of the reasons you may consider keeping your 401(k) is if your company offers a stable value fund.  Stable value funds are only available in 401(k) or 403(b) plans.  Stable value funds don’t fluctuate in price and pay a set amount of interest.  For example, the GM Income Fund, in the GM 401(k), pays 1.9% per year and the rate of interest is updated each quarter.  The benefits of stable value funds are that you don’t lose money, even when rates are moving higher.  In fact, as rates rise, stable value funds pay a little more interest and actually become more valuable.  The negative of stable value funds are that they are the most conservative investment in your 401(k), and when rates move lower,  you just get less interest paid to you.  As mentioned before, stable value funds are only available in certain 401(k) or 403(b) plans which offer these types of funds.  

Many of the bond ETFs mentioned in this article don’t have great performance over the past few years.  Many of these bond ETFs are low duration and lower yielding bond funds.  As interest rates rise, these funds will yield more and actually become more valuable.  Don’t make investment decisions based solely on past performance.  Especially now that rates went from going down for the past 35 years to moving higher. Shorter duration bond ETFs have struggled for years as interest rates have continuously come down.  Now that rates are on the rise, it will be more important than ever to keep duration low.  

Disclaimer:  This article is for education purposes only and does not imply a recommendation to buy or sell any securities.  I, or my clients, do not hold any of the previous securities mentioned and do not intend to initiate a new position.

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