The first Macro post on this website dealt with the effects of rising interest rates on sovereign debt constraints and financial markets. Given the reality of central banks throughout the world having raised interest rates at a rapid pace, investors must pay heed to the impact this could have on various asset classes.
Yield on 1 yr. US Treasury Bonds | Source: FRED
A common phrase in investing, “Don’t fight the Fed”, is tossed around by investors that roughly translates to choosing a more conservative investment strategy when interest rates are high or rising, and allocating more aggressively in a low or decreasing rate environment. This term is bandied about that much more during times of drastic policy transitions. But while it can sound like a cliche rule of thumb, investors inclined towards swimming against the Fed’s tide of interest rate hikes that have continued in 2023 may need to grapple with the dwindling probability of a Fed pivot. This is an institution that has continued to convey its willingness to hold rates “higher for longer”.
The Fed may eventually capitulate, but likely not without either a sharp decrease in inflation numbers or drastic economic pain. With a stock market that is still lower than the highs of 2021, but still not historically underpriced, the temptation of high yielding short term bonds will be hard to resist for investors seeking safety in choppy macro waters.
S&P 500 PE Ratio vs Historical Average | Source: currentmarketvaluation.com
If inflation continues to lower, an eventual Fed reversal on interest rates may increase the value of bonds. If a persistent inflation number causes more Fed action on rate hikes or Quantitative Tightening, having short term bonds as a ballast in an equity-heavy portfolio may offer downside protection. And right now, short term bonds are yielding much higher interest rates for those willing to hold them. Nothing is guaranteed when investing, but the upsides listed above could outweigh the potential downsides such as the interest rates not keeping up with inflation, or equity returns outpacing fixed income.
Asset Class Flows Jan 2023 | Source: ETF.com
With yields over 5% on <1 year Treasuries, the desire to carry “risk-free” assets has become a more fruitful portfolio position for the first time in a long time. Probably the simplest way to do this is through a Money Market account. For those wanting quick access to their funds, with relatively high interest rates, this may be the best method. An alternative and relatively easy and conservative way to gain exposure to higher interest rates is by investing in short term bond ETFs such as $VSB, $VGSH, $SHO, $SPSB, or ultrashort bond ETFs such as $ICSH, $VUSB, $FLDR from one of the major ETF providers. There are countless examples of similar funds, so these examples are by no means an exhaustive list of viable options. Some of these examples invest solely in US Treasuries, some in corporate bonds, and some in variations of both.
One of the many options for straightforward access to riding the tides of rising interest rates is the Vanguard Short-Term Treasury ETF $VGSH. Having a rock bottom expense ratio of 0.04% and an investment solely in US Treasuries, you can cheaply buy into a conservative investment that is providing higher and higher yields every month as the Fed raises rates and the bonds role over periodically.
Importantly, the low maturity length, which currently sits at 1.9 years long may give investors more peace of mind than longer dated funds, as unexpected rate rises in the future may cause long dated bonds to lose value. Extending out the maturity of your investments could be an alternative strategy to consider as well, though you have to consider duration risk more as you do this. Unlike an individual bond investment, a bond ETF is not guaranteed to return you the face value after maturity, as they trade openly on exchanges and generally will be consistently purchasing new bonds.
Current Facts About $VGSH | Source: Vanguard
Another option investors may want to look into is the iShares Ultrashort Bond ETF.
With an effective Duration of 0.45 years, the $ICSH is another example of how you can access these rising interest rates without the duration risk. And with an expense ratio of 0.08%, buyers of the fund pay $8.00 per year for every $10,000.00 invested, while $ICSH is currently on pace for $400-$500 in interest in that same time period. To get an idea of the relative sense of price stability for this security since its inception in 2013, it’s lowest price on record
Portfolio Characteristics of $ICSH | Source: iShares.com | Prospectus
For individual investors, uncertain and unnerving times shouldn’t necessarily dictate portfolio construction. Likely, sticking to the long term plan with little to no deviation is prudent. But for those looking for a safer investment than equities while capturing some higher yields, short term bond ETFs could act as a simple avenue for this type of exposure.