Case Summary

To preserve wealth and generate some income, Jim moved a healthy portion of his portfolio to Long Term Treasury Bonds.  However, the improving economy combined with the Fed’s massive monetary response to the financial crisis has Jim concerned about the potential for a rising interest rate environment within the next 12 to 18 months.

Rising interest rates will likely erode the principal value of Jim’s investment in long term treasuries.  How can he reshape his portfolio in a way that will help protect his wealth and income in case interest rates do go up?

Analysis

When it comes to fixed income investments, the longer the term or duration, the more sensitive the asset will be to changing interest rates.  This is especially true for Government bonds whose value tends to be isolated from other factors such as economic or industry conditions.

One option for Jim is to move to shorter term government bonds. This would reduce the sensitivity of his portfolio to interest rate movements but will also lower his current income as he moves down the yield curve.

Another choice would be for Jim to move to fixed income investments that are less sensitive to Fed actions.  For example, the principal value of high yield corporate bonds or international government bonds are driven by other factors besides U.S. treasury yields.  Some ETFs now invest in floating rate notes which adjust as interest rates change.
Hedging is another possibility.  Rising interest rates will not only hurt the value of long term Treasuries, but also industries that are interest rate sensitive such as housing, financial services and utilities.  Put options on ETFs and proper use of inverse ETFs can be effective hedging vehicles.

Portfolio Recommendations

Shorter term U.S. government bonds are accessible via ETFs such as the Barclays 1-3 Year Treasury Bond Fund (SHY) which tracks an index of most U.S. securities with a remaining maturity of between 1 and 3 years.  Other short term government bond ETF choices include the Vanguard Short Term Bond ETF (BSV),PIMCO 1-3 Year U.S. Treasury Index Fund (TUZ), and the WisdomTree U.S. Short-term Government Income Fund (USY).

High yield bond exposure can be gained through the SPDR Barclays Capital High Yield Bond ETF (JNK).  JNK tracks an index that includes publicly issued U.S. dollar denominated, non-investment grade, fixed-rate, taxable corporate bonds that have a remaining maturity of at least one year, are high-yield and have $600 million or more outstanding face value. Other high yield ETFs include iBoxx $ High Yield Corporate Bond Fund (HYG) and the PowerShares High Yield Corporate Bond Portfolio (PHB).

For access to international treasuries, Jim should consider the SPDR Barclays Capital International Treasury Bond ETF (BWX) or iShares S&P-Citigroup International Treasury Bond Fund (IGOV).  BWX tracks an index of fixed-rate local currency sovereign debt of investment-grade countries outside the United States.

For floating rate exposure, Jim should look into the VRDO Tax-Free Weekly Portfolio (PVI).  The fund invests in VRDOs which are high-quality, floating-rate bonds that provide investors with tax-exempt income in a short-term time frame.

Inverse ETFs should be used with care since they are typically designed for daily performance, after which they could diverge from their target strategy.  The ProShares UltraShort 20+ Year Treasury (TBT) targets twice (200%) the inverse (opposite) of the daily performance of the Barclays Capital 20+ Year U.S. Treasury Index.

For additional ETF investing choices, see the ETF Directory.