ETF picks for a rising rate environment

Central banks around the world are getting aggressive in an effort to curb soaring inflation. On June 15 the Federal Reserve raised the benchmark federal funds rate by 75 bps, bringing the target range to between 1.50% and 1.75%. The following day, the Bank of England agreed to raise rates for the fifth consecutive time in a row, increasing the Bank Rate to 1.25%.

These actions will have significant effect on fixed income markets. The short end of the yield curve is particularly sensitive to the actions of central banks. Due to the inverse relationship between bond yields and price, rising rates will be a headwind for bond returns. But there are some areas of the bond market that are less sensitive to interest rates and can offer protection for your fixed income allocation.

Short Duration ETFs

Duration is the measure of a bond’s sensitivity to interest rates, so it follows that short duration bonds are better suited for the rising rate environment we are currently in. Short duration ETFs target an overall duration of five years or less.

Using the Trackinsight ETF Screener to search for U.S. listed short duration ETFs shows several options available to investors. The Schwab Short-Term U.S. Treasury ETF (SCHO) is one of the highest-rated short-term ETFs available, tracking an index of Treasury securities. Meanwhile, for those who want corporate bond exposure, an ETF like the SPDR Portfolio Short Term Corporate Bond ETF (SPSB) that tracks an index of investment-grade corporate bonds could be used.

Both ETFs have significantly outperformed the iShares Core U.S. Aggregate Bond ETF (AGG) this year. Through market close on June 15, SCHO has fallen by -3.6% this year while SPSB has fallen by -3.9%. This is compared to an -11.5% drop for the broad-based AGG, which has a duration of. 6.5 years. 

European investors can use the Trackinsight Fixed Income ETF screener using the following filters: Fixed Rate, Investment Grade, and 1-5 Years. Options include funds like the iShares $ Treasury Bond 1-3yr UCITS ETF (IBTS) and the Vanguard USD Corporate 1-3 Year Bond UCITS ETF (VDCA).

Ultrashort Bond ETFs 

For even less interest rate risk, there are even ultrashort bond ETFs that target a duration of one year or less. Popular options for U.S. investors include funds like the JPMorgan Ultra-Short Income ETF (JPST) or the Vanguard Ultra-Short Bond ETF (VUSB), while European investors could opt for something like the iShares $ Treasury Bond 0-1 yr UCITS ETF (IB01). 

These ETFs have protected well this year during one of the worst years for fixed income on record, falling by -1.4% or less through June 15.

Interest Rate Hedged ETFs

Another interesting option would be ETFs that use a combination of long and short exposures to strip out interest rate risk. The iShares Interest Rate Hedged Corporate Bond ETF (LQDH) is one such option, taking a long position in the iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD) while shorting Treasury futures in order to bring net duration to zero.

The performance differential so far this year emphasizes just how difficult rising rates have been for ETFs that have exposure to interest rate risk. While LQDH has only fallen by -3.9% through June 15, LQD has dropped by -16.8%. LQD has an effective duration of 8.7 years. 

LQDH is also available for European investors.

Just the beginning for rising rates

While the Federal Reserve hasn’t raised rates this aggressively since 1994 and Fed Chairman Jerome Powell referred to the increase as an “unusually large one”, he also gave guidance that further moves are to be expected.

The revised dot plot, a chart that shows Fed members projections of the future path of rates, showed a midpoint of 3.4%. by year end. With the rising rate environment almost certain to persist into the future, investors might want to consider minimizing duration of their fixed income allocations using ETFs like these until inflation is brought under control.