A reader recently sent me a question asking why you would own a bond fund when interest rates are on the move higher. This type of sentiment is more than likely on the minds of many investors as they prepare for 2017 and evaluate adjustments to their asset allocation.
The short answer is that every diversified portfolio should have bond exposure to balance out the risk of other asset classes – i.e. stocks and commodities. Bonds have historically provided a shock absorber for the equity side of the portfolio and have not shown any signs of relinquishing that trait. Simply letting go of all your bond exposure will unnecessarily tilt your risks and returns towards a single outcome.
It’s like driving without a seat belt on. Everything will be fine, until it’s not.
Furthermore, bonds provide a much-needed stream of income for those what rely on dividends. A rising rate environment will depress bond prices, but it will also stimulate higher yields across virtually every sector of the bond market.
The benchmark that most investors will base their bond performance against is the Barclays U.S. Aggregate Bond Index. This is the same index that the two largest bond ETFs in the world are based on. Those being the iShares Core U.S. Aggregate Bond ETF (NYSEARCA:AGG) and Vanguard Total Bond Market ETF (NYSEARCA:BND).
These funds share a combined $73 billion in passively managed assets. They are also susceptible to more interest rate risk due to high concentrations of Treasuries, investment grade corporate bonds, and mortgage-backed securities.
Fortunately, there are several core bond ETFs that have managed to successfully mitigate the risk of rising rates through security selection and duration positioning.
Vanguard Short-Term Bond ETF (NYSEARCA:BSV)
If your goal is low cost and index-like returns, you can’t go wrong with a fund like Vanguard Short-Term Bond ETF (NYSEARCA:BSV). This Vanguard ETF takes the approach of significantly shortening the duration of its holdings versus a traditional intermediate-term benchmark. BSV has an effective duration of 2.8 years versus 5.9 years in BND. Remember that effective duration is essentially the measure of a fund’s sensitivity to interest rate fluctuations.
BSV charges an ultra-low expense ratio of just 0.06%, has exposure to 2,400 underlying holdings, and nearly $20 billion in assets under management. The portfolio is allocated using similar sector exposure to the Barclays Aggregate index, with the majority of holdings rated as high credit quality.
The downside to Vanguard Short-Term Bond ETF (NYSEARCA:BSV) is going to be its meager income stream. The fund currently sports a 30-day SEC yield of just 1.69% and income is paid monthly to shareholders. Such is the trade-off of lowering price volatility at the expense of the dividend payments.