This article was originally published at The Humble Dollar
As interest rates head higher, where should bond investors turn?
A lot of ink has been devoted to Series I savings bonds—for good reason. The initial yield, which applies to bonds bought through April, is north of 7%. Come May 1, it might go even higher if the inflation rate continues to climb. The recent energy price surge wasn’t fully reflected in the February’s Consumer Price Index, so the coming months’ reports could be even more alarming.
Problem is, there’s a limit to how much you can invest in Series I bonds, which are sold through TreasuryDirect, plus there’s an annual purchase cap of $10,000. You can also put up to $5,000 of your federal income-tax refund into I bonds, though you must take delivery of physical bonds. You then have the option of converting them to electronic form.
What if you have even more money to stash in bonds? Check out short-term Treasury exchange-traded funds (ETFs). Right now, you can buy iShares iBonds Dec 2024 Term Treasury ETF IBTE (LON:IBTE) and earn a respectable, safe yield to maturity of around 2.2% a year over the next two-plus years. That beats the pants off a high-yield online savings account, which might offer a measly 0.5%. Other choices include the iShares 1-3 Year Treasury Bond ETF (NASDAQ:SHY) and Vanguard Short-Term Treasury ETF (NASDAQ:VGSH).
Why is there such a large yield gap between savings accounts and very low-risk Treasury funds? Short-term Treasury rates have jumped recently as the Federal Reserve starts to raise rates. The two-year Treasury rate, which was 0.2% six months ago, has vaulted above 2.1%. Another reason for the surge in near-dated maturities is the rapid rise in two-year inflation expectations. They were near 3.3% in mid-February and are now just shy of 5%.
Rates on the long end of the Treasury curve haven’t seen that kind of volatility. They also don’t offer much of a yield premium. The iShares 25+ Year Treasury STRIPS Bond ETF (GOVZ) yields just 0.3 percentage point more than the low-duration iShares 2024 fund mentioned above. A lower duration means you’ll suffer less should market yields rise. The effective durations are 2.2 years for the iShares 2024 fund and 27 years for the iShares 25+ fund. That means that, for every one percentage point rise in market interest rates, the 2024 fund will lose about 2.2%, while the more rate-sensitive iShares 25+ fund will decline by a whopping 27%.
As rates rise from here, investors should keep reviewing their bond and cash investments. Owning a short-term Treasury ETF strikes me as a good choice right now, but that may change if yields spike higher across the bond market.
Some investors believe that owning bond ETFs and mutual funds, rather than individual bonds, is a mistake. I take issue with that. There’s a fallacy out there that bond funds are extra risky since a bond fund never matures, unlike an individual bond, which can be redeemed at maturity for its par value.
But consider this: A bond fund is comprised of individual bonds. Whether you own a basket of individual bonds or a bond fund, it’s essentially the same thing. Sure, when interest rates rise, a bond fund’s price drops—but so, too, does the price of an individual bond. In both cases, you’re looking at a potential loss if you need to sell right away. But when market interest rates rise, the bond fund offers a key advantage: It automatically invests proceeds from maturing bonds into new, higher-yielding bonds, plus it’s easy for shareholders to reinvest the interest they receive in additional fund shares.
Looking to invest in today’s bond market? Keep these four pointers in mind:
- Think about shifting out from savings accounts to a short-term Treasury fund now that rates have perked up.
- Find out the yield to maturity for the bond funds you’re interested in. That’s a good guide to your likely return.
- Check a fund’s duration. If a fund has a high duration, it’ll be roughed up by rising interest rates. Today’s low yields will likely provide scant compensation.
- Tempted to buy corporate bonds, with their higher yields? Remember, you’re taking credit risk. You’ll receive extra interest for assuming that risk—but those bonds will also fall harder than Treasurys if the economy starts to slow.