Best Bond ETFs for Rising Rates, Inflation

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As the growth outlook strengthens and the Federal Reserve responds with a tighter monetary policy, bond ETF investors will have to adapt to the changing market environment.

"Tax cuts and plans for more government spending are turning past headwinds to U.S. growth into tailwinds," BlackRock Strategists, led by Jeffrey Rosenberg, said in a research note. "One result: The market has now caught up with the median interest rate path projected by Federal Reserve policymakers."

Related: As Expected, Federal Reserve Delivers Rate Increase

Consequently, BlackRock now sees opportunities toward the front end of the yield curve, notably short-term debt.

"We see short-term U.S. debt offering relatively compelling income, with limited downside risk: Three Fed rate hikes are already priced in for this year, with the first likely this month," the BlackRock strategists said. "Markets could price in one additional quarterly hike after that Fed meeting (making a total of four for 2018), but we see a more rapid pace as unlikely."

Furthermore, technical factors like higher U.S. Treasury bill issuance due to a rising federal budget deficit are also adding to the factors pushing short-term yields higher. As a result, short-term Treasuries may provide positive real yields for the first time since the financial crisis, with income sufficient to offset inflation.

Investors interested in going down the yield curve has a number of options to gain broad exposure to short-term U.S. Treasuries. For instance, the iShares Short Treasury Bond ETF (NASDAQ: SHV) is comprised of U.S. Treasury obligations with a maximum remaining term to maturity of 12 months - SHV shows a 1.56% 30-day SEC yield and a 0.39 year duration. The iShares 1-3 Year Treasury Bond ETF (NYSEArca: SHY) tracks Treasuries with a one to three year maturity - SHY has a 2.13% 30-day SEC yield and a 1.92 year duration.

The BlackRock strategists also point to floating rate and inflation-linked securities to buffer against rising rates and inflation.

The iShares Treasury Floating Rate ETF (NYSEArca: TFLO), provides exposure to U.S. floating rate Treasury bonds, whose interest payments adjust to reflect changes in interest rates. TFLO shows a 1.45% 30-day SEC yield and a 0.01 year effective duration.

The iShares 0-5 Year TIPS Bond ETF (NYSEArca: STIP) tracks short-term U.S. TIPS, which are government bonds whose face value rises with inflation. STIP has a 3.76% 30-day SEC yield and a 2.53 year duration.

For more information on the fixed-income market, visit our bond ETFs category.

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