The U.S. inflation rate rose 4.2% year-over-year in May, marking its highest rate in three years. The Federal Reserve recently kept its benchmark rate unchanged at 3.50%-3.75%, but many analysts anticipate rate hikes later this year if inflation continues to rise.
By raising interest rates, the Fed aims to temporarily throttle economic growth to reduce inflation to its 2% target. But doing so will make stocks — which are driven by economic growth and low lending costs — much less attractive. So is the answer to invest in some bond ETFs instead?
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Traditional bond ETFs will also struggle when interest rates rise
Traditional bond ETFs, such as the Vanguard Total Bond Market ETF (NASDAQ: BND), hold a mix of government and corporate bonds. Inflation hurts these bond ETFs in two ways.
First, inflation can rise at a faster rate than the yields of these ETFs, giving you a negative return. BND currently has a 30-day SEC yield of 4.5%, which is barely ahead of inflation. Second, the Fed’s interest rate hikes will reduce the prices of existing bonds with lower yields, since income-seeking investors will flock toward newly issued, higher-yielding bonds.
But inflation-protected bond ETFs will thrive
To counter that pressure, financial institutions launched inflation-protected bond ETFs that continuously buy and sell bonds to keep your principal value tied to the Consumer Price Index (CPI). So when inflation rises, the value of your principal increases accordingly. The ETF’s coupon rate is applied to the adjusted principal, boosting your interest payments.
The Vanguard Short-Term Inflation-Protected Securities ETF (NASDAQ: VTIP) is the biggest ETF in this space. It pays a much lower 30-day SEC yield of 1.05%, but it’s designed as a hedge against inflation rather than a higher-yielding income investment.
Floating-rate ETFs, like WisdomTree’s Floating Rate Treasury Fund (NYSEMKT: USFR), reset their Treasury holdings every week based on the highest accepted discount rate of the most recent 13-week Treasury Bill auction. By doing so, it shields your investment from interest rate hikes rather than directly indexing it to inflation. That’s why its current 30-day SEC yield of 3.59% is directly comparable to the Fed’s benchmark interest rate.