So what’s an investor to do in a rising rate environment?

Market Realist

Why less can be more when it comes to investing (Part 2 of 2)

(Continued from Part 1)

If you have a bond portfolio that’s heavy with long-term bonds, you can potentially reduce your interest rate risk by rebalancing your portfolio to increase exposure to short-term bond ETFs. The iShares Short Maturity Bond ETF (NEAR ) seeks to maximize income through diversified exposure to short-term bonds. With one fund, you can potentially add diversification while seeking to reduce your interest rate risk at the same time.  You don’t have to shift your entire bond portfolio to shorter-term bonds; just enough to balance the rest of your long-term bond portfolio.

Or, maybe you’re sitting on cash. You know that every day spent sitting on cash is a day that your money is not working for you, but you’re stuck. Maybe you feel a little bit like Goldilocks: you’re equally nervous about the bond market (too risky to buy long term bonds now, if they’re about to lose money!) and the stock market (too volatile). For you, short-term bond ETFs may be just right. Put your cash back to work with something like the iShares Floating Rate Bond ETF (FLOT ), which offers access to 300+ investment-grade floating rate short-term bonds in a single package. Floating rate note coupons are designed to rise with short-term interest rates, which can help you keep up when short-term rates rise.

Regardless if you’re starting out with long-term bonds, or no bonds at all, toe dipping into short-term bonds can help you stay invested in the bond market—no matter where interest rates go.

The iShares Short Maturity Bond ETF is actively managed and does not seek to replicate the performance of a specified index. The Fund may have a higher portfolio turnover than funds that seek to replicate the performance of an index. Fixed income risks include interest-rate and credit risk. Typically, when interest rates rise, there is a corresponding decline in bond values. Credit risk refers to the possibility that the bond issuer will not be able to make principal and interest payments.

Securities with floating or variable interest rates may decline in value if their coupon rates do not keep pace with comparable market interest rates. The Fund’s income may decline when interest rates fall because most of the debt instruments held by the Fund will have floating or variable rates.

The iShares Short Maturity Bond ETF will invest in privately issued securities that have not been registered under the Securities Act of 1933 and as a result are subject to legal restrictions on resale. Privately issued securities are not traded on established markets and may be illiquid, difficult to value and subject to wide fluctuations in value. Delay or difficulty in selling such securities may result in a loss to the iShares Short Maturity Bond ETF.  The fund may invest in asset-backed (“ABS”) and mortgage-backed securities (“MBS”) which are subject to credit, prepayment and extension risk, and react differently to changes in interest rates than other bonds. Small movements in interest rates may quickly reduce the value of certain ABS and MBS.

Market Realist – As the graph above shows, short-term bonds and floating-rate bonds are, by and large, unaffected by changes in interest rates. Both types of bonds have lower duration, yet the reason for this is different for each. Short-term bonds have low duration due to their shorter maturity, so chances in interest rates won’t affect the cash flows for long before the bond matures. It’s important to keep in mind that short-term bonds will have a lower yield than longer-term bonds, given the higher certainty of repayment over a shorter horizon.

In the case of floating-rate bonds, the floating coupon “floats” on top of a benchmark rate. The coupon gets adjusted up and down as rates increase or decrease, changing the yield of the bond to roughly match the current respective yield in the market and therefore maintaining a stable price for the bond.

To learn more about the differences between short- and long-duration ETFs, see the Market Realist series  Comparing short- and long-duration ETFs over the last 6 months .

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