An Efficient Fixed Income Strategy When Interest Rates Are Rising

Interest rates are near historic lows and will begin to rise again at some point. An emergence from the recession could possibly indicate rising rates in the future as the Fed attempts to temper economic growth. Rising interest rates can mean bad news for fixed income investors, because as interest rates rise, bond values typically decline.

Fortunately, there are a few alternatives available for those in this category that can allow them to preserve the value of their bond holdings in a rising rate environment. One possible strategy that may be appropriate is to invest a part of your fixed income portfolio in short-term exchange-traded bond funds (ETFs). ETFs are liquid investment vehicles that are bought and sold on the major stock market exchanges, such as the New York Stock Exchange (NYSE) and the NASDAQ market. ETFs have grown in popularity among investors because of their relative costs.

But why invest in a short-term bond ETF? First of all, short-term bonds have an advantage over long-term bonds during periods when interest rates are rising. As the shorter-term bonds reach maturity in an investor’s portfolio, they can be replaced with higher-yield bonds. Long-term bond investors might either have to wait until their bonds reach maturity before replacing them with higher-yield securities or sell their bonds on the open market at a lower price.

Exchange-traded funds also differ from standard mutual funds in that ETFs are not actively managed. Rather than relying on the expertise of a professional portfolio manager to pick and choose the best bonds to own, a fixed income ETF typically seeks to mimic the entire market as a whole. This can be an efficient investment strategy in a less volatile market such as the short-term bond market. Plus, without the higher expenses for investment management fees, a fixed income ETF can sometimes return a greater share of any investment gains to its shareholders.

However, ETFs are not appropriate for everyone. If you invest by regularly putting small amounts of money into the market at regular intervals--you can incur significant brokerage commissions, which you'll have to pay every time you buy another set of ETF shares. That can reduce your returns, even if you trade online and pay less than $10 per transaction. It should also be remembered that like mutual funds, ETFs are an investment that fluctuates with market conditions, and your shares may be worth more or less than original cost upon redemption.

By Mark C