Conventional wisdom often dictates that rising interest rates can be a pain for investors. Unfortunately, the Federal Reserve has boosted borrowing costs four times since the start of 2017, including once to this point this year. Some bond market observers still see interest rates climbing multiple times before the end of 2018.
Investors can endure, even thrive rising interest rates by knowing where and where not to be as the Fed tightens. Some asset classes and sectors are inversely correlated to rising interest rates. At the sector level, that includes groups with bond-like traits, such as real estate, telecommunications and utilities or other assets known for income-generating potential.
There are ways investors can protect their portfolios against rising interest rates and the fund universe, including exchange-traded funds (ETFs) and mutual funds, makes that objective easier.
Consider the following ideas as buffers against rising interest rates.
Invesco S&P 500 Ex-Rate Sensitive Low Volatility ETF (XRLV)
Expense Ratio: 0.25% annually, or $25 per $10,000 invested
Low volatility investing is often popular, but this concept can be vulnerable amid rising interest rates. One of the reasons that low volatility funds face headwinds when borrowing costs climb is because these funds usually feature large allocations to rate-sensitive sectors. That confirms the notion that there is no free lunch in financial markets. The trade-off for reduced volatility among stocks can often mean sensitivity to rising interest rates.
The Invesco S&P 500 ex-Rate Sensitive Low Volatility ETF (NYSEARCA:XRLV) helps investors deal with that problem. XRLV, which is over three years old and holds 100 stocks, follows the S&P 500 Low Volatility Rate Response Index. XRLV’s 100 components are S&P 500 members displaying favorable volatility characteristics as well as reduced sensitivity to rising interest rates. XRLV’s index has been a winner over the long-term.
“Over the longer time horizons, the low volatility and rate response indices outperformed the S&P 500, with lower volatility,” according to S&P Dow Jones Indices. “In fact, the rate response index performed better than both the low volatility index and the S&P 500 for all measured periods. The rate response index was slightly more volatile than the low volatility index — nevertheless, it had a cumulative risk reduction of 19.3% relative to the S&P 500 (the low volatility index had a risk reduction of 23%).”
XRLV is proving it works when there are rising interest rates. The fund is up 3.4% year-to-date while a traditional, widely followed low volatility index is slightly lower.
Fidelity Total Bond Fund (FTBFX)
Expense Ratio: 0.45%
The Fidelity Total Bond Fund (MUTF:FTBFX) requires a minimum investment of $2,500. While rising interest rates can be punitive for longer-dated Treasuries, some corners of the fixed income universe are not as rate-sensitive as investors may believe.
This Fidelity fund analyzes “the credit quality of the issuer, the issuer’s potential for success, the credit, currency, and economic risks of the security and its issuer, security-specific features, current and potential future valuation, and trading opportunities to select investments,” according to the issuer.
FTBFX has outperformed the Bloomberg Barclays U.S. Universal Bond Index over the past five years, 10 years and since inception. The fund has a 30-day SEC yield of 3.23% and a duration of 5.63 years. Eighty-four percent of FTBFX’s holdings carry investment-grade ratings.
iShares Edge U.S. Fixed Income Balanced Risk ETF (FIBR)
Expense Ratio: 0.25%
Many bond funds do one of the following: guard against credit risk or rising interest rates. Few protect against both risks. The iShares Edge U.S. Fixed Income Balanced Risk ETF (CBOE:FIBR) is an actively managed fund that “targets an equal allocation between interest rate and credit spread risk,” according to iShares.
FIBR can establish short or long positions in U.S. Treasury futures and short positions in U.S. Treasury securities through interest rate swaps, along with other interest rate instruments.
FIBR, which holds nearly 800 bonds, has an effective duration of 5.08 years and a 30-day SEC yield of 3.56%.
“FIBR systematically incorporates strategies used in traditional active portfolios,” said BlackRock in a recent note. “For example, FIBR invests only in asset classes that have historically had high risk-adjusted returns. And FIBR tilts towards higher yielding asset classes and securities. These traditional active strategies are just wrapped up into an index and implemented consistently through time in an ETF.”
ProShares Equities for Rising Rates ETF (EQRR)
Expense Ratio: 0.35%
The ProShares Equities for Rising Rates ETF (NASDAQ:EQRR) is a new addition to the rising interest rates funds fray, having debuted 11 months ago. At its core, EQRR is designed to outperform traditional large-cap indexes when interest rates are climbing and attempts to do so by allocating to sectors and industry groups with a history of rising interest rates durability.
In other words, this is not the fund for investors looking for big weights to rate-sensitive sectors like consumer staples or utilities. Rising interest rates do not always spell bad news for stocks, but cyclical sectors are where investors want to be as rates climb. EQRR devotes 30.3% of its weight to financial services stocks, the sector is often most positively correlated to rising interest rates. Energy and industrial stocks combine for 42.7% of the fund’s weight.
This is a focused fund with sector exposure to only 5 sectors and 50 holdings. Amid rising interest rates, EQRR is doing its job. The ETF is up 9.7% this year, or more than double the gains of the S&P 500.
As of this writing, Todd Shriber did not own a position in any of the aforementioned securities.