Fixed-income investors faced difficult decisions for the past few years. Investors who buy bonds are accepting a small reward in a low interest rate environment. Holding bonds means accepting large risks, because if rates rise, the value of the bonds will fall.
In this environment, bond funds seem to make more sense than individual bonds, since fund managers can take action to decrease risks if rates do rise.
While bond funds and ETFs lower the risk of owning bonds, they do not really increase the potential rewards. Rates are low and are likely to remain low for some time. This means it is important to find the best funds, which are the ones that balance the risks and rewards.
Most economists agree that rates will rise when the rate of inflation increases. That is not likely to happen anytime soon in the U.S. or in any of the world's largest economies where official inflation numbers are low. However, most experts believe that yields are likely to move up in other countries before they do in the U.S.
iShares 1-3 Year International Treasury Bond (ISHG) is an ETF that can take advantage of global markets by going where yields are rising. The fund currently invests in about 100 different government-issued bonds and reports an average yield on those bonds of 0.83%. This is more than a three-year U.S. Treasury note offers, but ISHG has about the same degree of risk as short-term Treasuries.
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ISHG's largest holdings are currently in bonds issued by governments in Japan, Italy and Germany. Its single largest holding is a bond issued by Norway. In addition to earning interest from its holdings, ISHG can benefit from changes in the currencies of those countries, and that should account for part of the fund's gains if the managers are able to position their holdings correctly.
Even though ISHG is a top pick according my 26-week rate of change (ROC) system, the ETF is only offering a small amount of income and likely has limited upside potential. Given these realities, some readers might be asking why they should buy it. The answer is threefold:
1. The dividends ISHG offers are larger than the returns generally available on cash.
When following my 26-week ROC system, the alternative to being invested in a particular segment is cash, and the average money market account is paying 0.42%. Over the past 12 months, the yield on ISHG was 0.66%.
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2. ISHG could help stabilize a portfolio if there is a rapid reversal in the stock market.
Many investors are worried about a stock market crash. Holding assets other than stocks will help reduce the downside if this fear comes to fruition. Bonds are a traditional component of a balanced portfolio, and ISHG is the highest-rated bond fund in the 26-week ROC system.
3. ISHG does offer some upside potential.
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The difference between the 52-week high and low for ISHG has been 8.9% over the past 12 months. This is a sizable trading range and demonstrates that there is some upside in the ETF.
There are no other trades in the 26-week ROC system this week. The portfolio will hold five positions after the addition of ISHG: