Most consumers are acutely aware of rising inflation, but the Fed Funds rate remains at just a quarter-point. In March, interest rates will almost certainly begin to rise as the central bank moves to contain inflation levels that haven’t been seen since the 1980s. As a result, fixed-income investors may want to prepare their portfolios for impact.
Let’s take a look at why interest rates are likely to continue rising, why ultra-short-term bond ETFs are in vogue, and some alternatives to consider for your portfolio.
Don’t forget to check our Fixed Income Channel to learn more about generating income in the current market conditions.
Interest Rates on the Rise
The annual inflation rate rose from 7% in December to 7.5% in January, according to the Bureau of Labor Statistics, reaching its highest level since February 1982. Consumer prices surged greater-than-expected 2.1% in January, while Russia’s invasion of Ukraine sent oil prices above $100 per barrel for the first time since 2014, adding inflationary tailwinds.
In addition to crude oil prices, a protracted Russia-Ukraine war could disrupt other markets. For instance, Russia accounts for 25% of global wheat exports, and Ukraine accounts for 13% of corn exports. As a result, wheat prices soared to their highest levels since 2012. Likewise, corn and soybean prices rose sharply higher in the aftermath.
The futures market predicts a 64% probability of a quarter-point rate hike in March, with 36% expecting a half-point rate hike. Meanwhile, JPMorgan economists believe that the Federal Reserve will increase interest rates by 25 basis points at each future policy meeting until March 2023 to control soaring inflation, according to Barron’s.
Ultra Short-Term Bond ETFs
Higher interest rates are bearish for bond investors, and long-term bonds suffer the most. After all, investors don’t want bonds that lock them into low rates for extended periods. Therefore, investors typically look toward low-duration fixed-income investments that aren’t as sensitive to rising interest rates—or ultra-short-term bonds.
Ultra-short-term bonds have maturity dates two years or less in the future. As a result, investors can replace maturing bonds in their portfolios more frequently at higher interest rates (if they’re on the rise), resulting in a higher overall portfolio yield. Ultra-short-term bond ETFs add an extra level of diversification by holding many bonds in one security.
The most popular ultra-short-term bond ETFs include:
Alternatives to Consider
Fixed-income investors looking for more yield than ultra-short-term bonds have several options. For example, floating-rate securities adjust to interest rate changes over time, whereas real estate owners can quickly adjust their rental rates to account for increasing inflation. Inflation-protected bonds, like I-Bonds, can also help fight inflation.
Some options to consider include:
- Global X S&P 500 Covered Call ETF (XYLD)
- Columbia Research Enhanced Value ETF (REVS)
- Vanguard Real Estate ETF (VNQ)
Be sure to check our Portfolio Management Channel to learn more about different portfolio rebalancing strategies.
The Bottom Line
Inflation is on the rise and interest rates are sure to follow. Fixed-income investors seeking to protect their portfolios are turning to ultra-short-term bonds as a short-term fix. However, real estate, floating-rate, and inflation-protected bonds could provide protection with a higher yield.
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