Bond ETFs can help clients navigate rising rates

Three ways advisers can utilize bond ETFs to ride out whatever waves the Fed's long-deferred action might kick up.

Make no mistake: The Fed will raise interest rates. Although the timing of the next Fed move is difficult to pin down, it’s not too early to think about what it might do to your clients’ bond investments. Nor is it too early to get ready for queries from clients eager to make sure their bond portfolios are properly positioned to ride out whatever waves the Fed’s long-deferred action might kick up.

Many advisers already look to bond ETFs as a low-cost, tax-efficient solution for a wide range of clients looking to build diversified portfolios. However, a changing rate environment is bringing an additional set of portfolio applications to the fore.

Here are three ways advisers can utilize bond ETFs in an effort to navigate a rising-rate environment:

1. Shortening bond portfolio duration

Most bond ETFs are index-based, enabling investors to easily tap specific segments of the bond market through the ETFs that seek to track them. The level of duration in an ETF is fairly steady through time, as a fund will remain invested in the target market.

For example an index of one- to three-year bonds tends to have a duration of around two years. This gives advisers the ability to manage the level of interest-rate risk that clients are exposed to and shorten duration when necessary.

A wide range of short-duration ETFs provide exposure to government bonds, corporate debt and other segments of the market. This range of options gives advisers great flexibility in finding an appropriate ETF for their clients’ portfolios.

One option that may be well-suited for when the Fed raises rates is floating-rate-bond ETFs. These funds invest in investment-grade corporate or Treasury bonds whose coupons reset with changes in short-term interest rates. When the Fed begins to raise short-term rates, the coupons on these securities will begin to rise, potentially providing an investor with an income boost. As a bonus, as a result of the nature of floating-rate bond coupons, floating-rate bond ETFs have a duration of less than a quarter of a year.

2. Putting the focus on credit exposure

The challenge with reducing interest-rate risk is that it generally will result in investors giving up yield. Investors can aim to address this by increasing the amount of credit risk in a portfolio. Interest-rate risk and credit risk are the two primary drivers of returns in a bond portfolio, and they are also the two main sources of income.

As rates trend up, advisers should look to reduce interest-rate exposure in their clients’ portfolios, focusing on credit exposure for a better balance of risk and reward.

To that end, advisers and clients might consider short-maturity-corporate-bond ETFs. These funds have low levels of interest-rate risk while at the same time providing some income from credit risk. An adviser seeking a small income boost may look to an investment-grade fund, while an adviser seeking more income can look to high yield.

3. Putting cash to work

While investors face challenges on how to invest in a rising-rate environment, they also find themselves looking for ways to put cash to work. What they don’t want to do is put their money in the bond market and then see their investment get hit if interest rates climb. At the same time, they don’t want to see inflation erode the value of their cash. Although inflation has been running between 1% and 2% recently, even that low level is enough to make the real return on some cash investments negative.

Short-term bond ETFs potentially can provide a solution that delivers income without taking on undue levels of interest-rate risk. This helps get cash working in the market again in an investment that can help overcome the potential loss of purchasing power from inflation. Advisers might consider diversified multisector- and corporate-bond ETFs.

Rising rates will pose challenges to fixed-income portfolios. As advisers consider the resources available to manage this next turn in the bond market cycle, bond ETFs should be on their list.

Matthew Tucker is the iShares head of fixed income strategy at BlackRock Inc.