Rising rates blog series: The double appeal of short-maturity bonds

As yields increase, short-maturity bond funds can offer both higher income potential and a cushion against interest rate risk. Karen explains the mechanics, in part three of her Rising Rates series.

One of the ways to navigate a rising rate environment is to reduce your exposure to bonds with greater levels of interest rate risk. For many investors, this means moving toward short-maturity bonds. In exchange for lower risk, these issues typically generate lower income than longer-maturity bonds.

The current market environment is unusual, however. A flatter yield curve means that short bonds are providing similar income to their longer-maturity counterparts–while still reducing interest rate risk.

Investors wanting to gain exposure to short-maturity bonds often do so through bond exchange traded funds (ETFs) or mutual funds, which typically hold a diversified portfolio of bonds with maturities less than five years.

Perpetual bond ladder

Fixed-rate short-maturity bond funds tend to act like a perpetual bond ladder, especially if the fund is an index fund with a defined maturity range, such as 1- to 3-year or 1- to 5-year. The fund’s portfolio manager rebalances the fund monthly, removing bonds at the low end of the maturity range and adding ones at the higher end. Over time, the portfolio adjusts to the new yield environment; as yields rise, the income increases on the portfolio.