3 types of ETFs that can help with rising rates

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By Karen Veraa

As widely anticipated, the Federal Reserve raised the Fed Funds rate from 0.25% to 0.25%-0.50% at the March Federal Open Market Committee (FOMC) meeting, its first ever rate hike. interest since December 2018. The Federal Reserve has a dual mandate; keeping stable prices (i.e. controlling inflation) and maintaining the economy at full employment. The central bank raised the federal funds rate to try to stay consistent with these goals:

  1. Stable Inflation: Higher interest rates have historically helped curb high inflation.
  2. Full employment: Many jobs have been created as the economy continues to recover from the effects of the global pandemic, giving the Fed the opportunity to raise interest rates to a level it says will not hurt not to economic activity and job creation.

In addition to the increase in fed funds rates, longer-term rates rose as the market priced in the path of future rate hikes. Rising interest rates can have a significant impact on bond investments, since bond prices fall when interest rates rise. However, bonds play a crucial role in portfolios as potential diversifiers and income generators.

Federal Funds Rate vs. 10-Year US Treasury Rate

Line graph comparing the federal funds rate and the yield on US 10-year Treasury bills from 1998 to March 2022

Bloomberg. As of 03/25/2022. The 10-year US Treasury Index is represented by the Bloomberg 10-20 Year US Treasury Index. The performance of the index is indicative only. Index performance does not reflect management fees, transaction costs or expenses. Indices are unmanaged and you cannot invest directly in an index. Past performance does not guarantee future results.

Bond ETFs are an inexpensive way to help mitigate interest rate risk in your portfolio. Investors can consider the ETFs listed below to protect against rising interest rates and supplement or replace existing bond holdings.

Interest rate hedged ETFs: iShares Interest Rate Hedged Long-Term Corporate Bond ETF (IGBH) and iShares Interest Rate Hedged High Yield Bond ETF (HYGH) provide a cost-effective means of seeking to mitigate interest rate risk through a fund-of-funds structure that uses interest rate swaps, which reduces exposure to interest rate risk while maintaining the credit exposure.

Floating Rate Note ETFs: iShares Floating Rate Bond ETF (FLOW) and iShares Treasury Floating Rate Bond ETF (TFLO) offer exposure to floating rate US bonds and floating rate US Treasury bonds, whose interest payments adjust to reflect changes in interest rates. Floating rate bonds in FLOT and TFLO tend to have a shorter duration than fixed securities due to frequent interest rate resets.

Short-dated fixed-rate ETFs: iShares 1-5 Year Investment Grade Corporate Bond ETF (IGSB) and iShares Core 1-5 Year USD Bond ETF (BIST) hold fixed rate bonds with maturity profiles of 1 to 5 years, which currently offer reduced duration compared to broader maturity indices. IGSB invests in high-quality, short-term US corporate bonds, while ISTB invests in short-term, multi-sector core bonds. In addition to taxable fixed income, investors can also seek to shorten the duration of municipal bond portfolios with iShares National Short-Term Municipal Bond ETF (UNDER) and BlackRock Short Maturity Municipal Bond ETF (MEAR).

Rising rates can weigh on bond yields. By investing in interest rate hedging, floating rates and shorter duration exposures, investors can help protect their bond investments from rising rates.

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Investing involves risk, including possible loss of principal.

Risks associated with fixed income securities include interest rate risk and credit risk. Generally, when interest rates rise, there is a corresponding fall in the value of bonds. Credit risk refers to the possibility that the bond issuer may not be able to make principal and interest payments.

Lower quality debt securities (high yield bonds/junk bonds) may be subject to greater market fluctuations, risk of default or loss of income and principal than higher rated securities.

There can be no assurance that interest rate risk will be reduced or eliminated within the Fund.

The use of derivatives by the Fund may reduce the Fund’s returns and/or increase volatility and expose the Fund to counterparty risk, which is the risk that the other party to the transaction will not fulfill its contractual obligation. The Fund could incur losses related to its derivative positions due to a possible lack of liquidity in the secondary market and as a result of unforeseen market movements, which losses are potentially unlimited. There can be no assurance that the Fund’s hedging transactions will be effective.

Investing in a fund of funds is subject to the risks and charges of the underlying funds.

There may be less information about the financial condition of municipal issuers than for public companies. The municipal bond market may be less liquid than the taxable bond market. Certain investors may be subject to federal or state income tax or Alternative Minimum Tax (AMT). Capital gains distributions, if any, are taxable.

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

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The strategies discussed are strictly for illustrative and educational purposes and do not constitute a recommendation, offer or solicitation to buy or sell securities or to adopt any investment strategy. There is no guarantee that the strategies discussed will be effective.

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This Publish originally appeared on iShares Market Insights.

Editor’s note: The summary bullet points for this article were chosen by the Seeking Alpha editors.