Interest rates have stabilized significantly this year from their tremendous rise in 2013.
However, many investors believe that yields will ultimately move much higher.
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The combination of the Federal Reserve tapering their asset purchase programs along with an eventual tightening of the Fed funds rate may significantly alter the landscape for fixed-income investors.
Fortunately, there are a variety of strategies that can be implemented to hedge exposure or even profit from the effects of rising interest rates.
One potential move to consider is shortening the average duration of your bond portfolio in order to reduce price sensitivity to interest rates. An ETF such as the Vanguard Short-Term Grade Corporate Bond Fund (NASDAQ:VCSH) holds a basket of investment grade debt of highly-rated companies with durations between one to three years.
This fund will not experience the same level of price volatility that an intermediate-duration fund such as the iShares Investment Grade Corporate Bond Fund (NYSE:LQD) will if interest rates significantly rise. The trade-off is that VCSH only pays a yield of 1.39 percent, while LQD currently yields 3.26 percent.
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Another strategy to consider is investing in an ETF that has built-in interest rate hedges such as the ProShares Investment Grade - Interest Rate Hedged ETF (BATS: IGHG). This fund is designed to be long corporate bonds and short treasury notes of similar durations in order to remove or dampen the effect of interest rate fluctuations on the portfolio.
In theory, the construction of this index should help smooth out volatility when compared to a traditional basket of bonds. However, fluctuations in the yield curve may still lead to some spillover that cant be perfectly addressed in every situation.
The final and most aggressive strategy is to consider a rising rate ETF such as the ProShares Short 20+ year Treasury Bond ETF (NYSE:TBF). This fund is designed to provide -1x price correlation to a basket of long-duration treasury bonds on a daily basis. Think of it as the inverse of the popular iShares 20+ Year Treasury Bond ETF (NYSE:TLT).
Rising rate ETFs have become more popular in recent years as investors have used them to hedge off their existing fixed-income holdings or as a pure play on the direction of Treasury yields.
The advantage is that you get direct correlation and targeting to a specific area of the yield curve depending on the ETF that you select. There are a variety of options from both ProShares and DirexionShares that may fit your portfolio characteristics or risk tolerance.
With these tools, investors can ultimately be prepared to weather any storm that interest rates throw their way.
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