Must know: Being prepared for the upcoming interest rate rise

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Must know: Do inflation-indexed bonds make for easier investments? (Part 4 of 4)

(Continued from Part 3)

Inferring from Fed’s new Chairman Janet Yellen’s statements, the ongoing tapering initiatives of the U.S. will continue. With that, one can expect a rising interest rate environment in the near future. As interest rates rise, bond prices will decline. This means, bonds and ETFs with higher average maturities and durations are more susceptible to interest rate risk caused by inflation. Also, in such a case, exchange traded funds (or ETFs) consisting of regular Treasuries, will lose more as compared to ETFs with TIPS in their portfolio, as the average yield in case of TIPS is adjusted to accommodate the effect of inflation. TIPS will not have much negative effect on its average yield, as the portfolio will be hedged against the interest rate risk attributed to inflation.

For example, the iShares 20+ Year Treasury Bond ETF (TLT), with a weighted average maturity of 27.31 years and an effective duration of 16.36 years, could see a price decline of 16.36% for every 1% rise in interest rates. The iShares 10-20 Year Treasury Bond ETF (TLH), with an effective duration of 9.75 years, is exposed to a price volatility of 9.75% for every 1% rise in interest rates.

On the other hand, the iShares TIPS Bond ETF (TIP) with a duration of 7.57 years will face a price decline of only 7.57% for a 1% rise in interest rates. Similarly, the FlexShares iBoxx 3-Year Target Duration TIPS Index Fund (TDTT), and the iShares 1-3 Year Treasury Bond ETF (SHY) with their effective durations of 3.04 years and 1.85 years, respectively, will perform better in a rising interest rate scenario.

As can be seen from the chart above, the TLT, with higher duration, shows more volatility than TIP, which has lower duration. Also, as seen in the chart in Part 1 of this series, over the years, TIPS ETFs have been able to perform better than Treasury ETFs in terms of real returns in inflationary conditions.

Considering the expected interest rates rise in the future, bonds and ETFs with inflation-linked feature should help the investors contain their downside risk.

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