Recent Rumblings From the Fed Could Make This Vanguard Bond ETF a Better Buy

The Federal Reserve might not be done raising interest rates to fight inflation. According to a June 30 interview with CNBC, Cleveland Federal Reserve President Beth Hammack said that the artificial intelligence (AI) boom could be causing inflation, with high demand for AI infrastructure and energy driving higher costs in the economy.

Hammack said: "We've got inflation that's too high, and it's been too high for the past five years. ... [W]hen I look at policy if that continues, it may mean that we need higher interest rates to bring inflation back down to target."

Hammack isn't the only member of the Federal Open Market Committee who gets to vote to set short-term interest rates. But if Hammack's analysis is on target and inflation is not "over" yet, that could motivate the Fed to raise interest rates later in 2026. That means anyone who's thinking about buying bonds might want to prepare for interest rate risk.

Let's look at the Vanguard Ultra-Short Bond ETF (NYSEMKT: VUSB) and see if it could be a smart choice for bond investors.

Image source: Getty Images.

Interest rate risk: Higher rates = lower bond prices

If you believe that interest rates are going higher in the short to medium-term future, you might want to buy short-term bonds today instead of longer-duration bonds. If interest rates go up, bond prices go down. That's called "interest rate risk" for bond investors.

Medium- and longer-duration bonds, such as 10- and 20-year Treasury bonds, are more sensitive to interest rate risk than short-term bonds. When the Fed raises interest rates, the price of bond ETFs declines, but longer-term bonds fall even more.

That means short-term bonds such as the Vanguard Ultra-Short Bond ETF could be a better buy today, especially if you want to manage cash or shorter-term holdings.

Vanguard Ultra-Short Bond ETF: 1,294 bonds, five years of 3.49% average annual returns

The Vanguard Ultra-Short Bond ETF is an exchange-traded bond fund that offers a portfolio of 1,294 bonds with an average duration of 1.0 years. It charges an expense ratio of 0.10%. As of July 2, it has delivered year-to-date returns (by net asset value) of 1.73%. It has delivered average annual returns (by net asset value) of 4.24% in the past year, 5.34% in the past three years, and 3.49% for the past five years.

This bond ETF's portfolio holds mostly corporate bonds. The top issuers represented in the fund are finance bonds (36.99% of the fund), asset-backed (26.97%), industrial (26.83%) and utilities (4.18%). The fund is intended to invest in high-quality bonds, and about 98.4% of the fund's portfolio are investment-grade corporate bonds, from companies with credit ratings of BBB or higher.

Short-term bonds are not completely safe from interest-rate risk. Not every bond ETF is the right choice for every bond investor. But if you're worried that higher interest rates will cause lower bond prices, and you want a low-cost fund that lets you manage that risk with short-term bonds, the Vanguard Ultra-Short Bond ETF could be a smart way to do it.

Ben Gran has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.