Which Fixed-Income ETFs Benefit from Rising Interest Rates?

Ultra-Short-Term Fixed Income

The simplest way to reduce the damage rising rates can inflict on bonds is to minimize duration. For this purpose, I'd go shorter than one year, focusing on securities that mature quickly enough for the portfolio to continually reinvest proceeds at prevailing rates.

That's the appeal of ultra-short-term fixed income in a hiking cycle. As the Fed raises rates, maturing securities can be replaced by newly issued ones carrying higher yields. Meanwhile, because duration is so low, the fund's net asset value generally experiences much less downward pressure from rising rates than an intermediate- or long-term bond ETF. From there, you can fine-tune the trade based on how much yield, credit risk and tax efficiency you want.

For maximum credit quality and potential state and local tax advantages, one option is the iShares 0-3 Month Treasury Bond ETF

. SGOV holds U.S. Treasury bills with three months or less remaining until maturity and currently has an effective duration of just 0.10 years. In rough terms, that implies only about a 0.1% price move for a one-percentage-point change in interest rates, all else being equal.

As of September 16, SGOV had a 3.65% 30-day SEC yield after its 0.09% expense ratio. I'd expect that figure to adjust upward as the Fed's latest hike works its way through newly issued T-bills and the portfolio turns over. SGOV also pays monthly distributions, which can be more convenient for income investors than buying individual T-bills that are generally issued at a discount.

If you're willing to accept some additional credit risk and potentially less favorable tax treatment in exchange for more yield, there's the Vanguard Ultra-Short Bond ETF

. It's remarkably inexpensive for an actively managed bond ETF, with a 0.10% expense ratio, and had a 4.52% 30-day SEC yield.

That yield pickup comes from giving the managers considerably more freedom than SGOV. VUSB can venture beyond Treasuries into investment-grade corporate bonds, asset-backed securities and other short-term fixed-income instruments. Its average duration is correspondingly longer at roughly 0.9 years, but that's still low enough to keep its sensitivity to changing interest rates relatively modest.

Floating-Rate Bonds

Another way to position fixed income for rising rates is with floating-rate debt. Unlike a conventional bond with a fixed coupon, a floating-rate bond periodically resets its interest payment based on a short-term reference rate plus a predetermined spread. Common benchmarks include the Secured Overnight Financing Rate (SOFR) and short-term Treasury bill yields.

The basic appeal in a hiking cycle is straightforward: as the benchmark rises, the coupon can reset higher. As with ultra-short-term bonds, investors can then decide how far out on the credit-risk spectrum they're willing to venture in pursuit of additional yield.

At the conservative end is the WisdomTree Floating Rate Treasury Fund

. USFR tracks the Bloomberg U.S. Treasury Floating Rate Bond Index, which holds floating-rate notes issued by the U.S. Treasury. These securities reset their interest rates based on the most recent 13-week Treasury bill auction rate. After its 0.15% expense ratio, USFR currently has a 3.69% 30-day SEC yield.

Compared with simply owning T-bills, USFR’s appeal becomes more apparent if short-term rates continue climbing. A T-bill locks in its return until maturity, whereas the coupon on a Treasury floating-rate note resets weekly based on the latest 13-week T-bill auction rate, allowing income to adjust without waiting for the security itself to mature. Conversely, if rates fall, that reset mechanism works against you as the coupon adjusts downward.

If you're willing to accept more credit risk for additional yield, one option is the VanEck IG Floating Rate ETF

. After its 0.14% expense ratio, FLTR currently has a 4.21% 30-day SEC yield.

FLTR isn't limited to U.S. government debt. Roughly 21% of the portfolio is rated AA, 58% is rated A and another 20% is rated BBB, placing virtually the entire portfolio within investment grade. Financial issuers dominate at roughly 81% of assets, while the portfolio is geographically diversified, with U.S. securities representing only about 42%.

Companies issue floating-rate notes for many of the same reasons they issue conventional bonds: to raise capital for operations, acquisitions, refinancing and other corporate purposes. For investors, the attraction relative to Treasuries is the additional credit spread paid as compensation for taking corporate default risk. If benchmark rates rise, the coupon can reset higher while that credit spread provides additional income on top.

Finally, investors willing to move below investment grade can look at the State Street Blackstone Senior Loan ETF

. Its 0.70% expense ratio is considerably higher, but so is its 6.53% 30-day SEC yield.

Senior loans are floating-rate loans typically made to below-investment-grade companies. "Senior" refers to where the debt sits in the borrower's capital structure. These loans are generally secured by company assets and rank ahead of unsecured bonds and equity in the repayment waterfall if the borrower defaults. That doesn't eliminate credit risk, but the senior secured position can potentially improve recoveries compared with more junior claims.

There's another wrinkle here: SOFR floors. According to State Street, 31.86% of SLRN's loans currently have SOFR floors, with a weighted-average floor of 0.55%. A floor establishes a minimum benchmark rate used to calculate the loan's coupon. If SOFR drops below 0.55%, those loans would continue calculating interest using at least that 0.55% base rate, plus their contractual credit spread.

With three-month SOFR currently around 3.98%, however, those floors are far out of the money and provide no immediate benefit. The loans are already resetting off a benchmark substantially above their floors. In today's environment, the important feature is their floating-rate exposure: if SOFR moves higher, their coupons can generally move higher as well. The floors become more valuable if rates subsequently fall far enough to approach those minimum levels.

Please note that this article reflects the author’s personal views and does not represent the opinions of the publication or its affiliates. It is for informational purposes only and does not constitute investment advice. It is essential to seek guidance from a registered financial professional before making any investment decisions.