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Where investors should focus their attention in the bond market

With the worry of a potential government shutdown — which Moody's cites as a hit to U.S. credit — and the Federal Reserve's "higher for longer" interest rates gathering steam over markets, investors are unsure where to hold investments. BlackRock Head of iShares Investment Strategy Gargi Chaudhuri joins Yahoo Finance to explain the movements in the bond markets and what investors should pay attention to during the shaky state of the economy.

Chaudhuri offers insights into how markets are reacting to interest rates based on where Treasury yield curves are now: "The 5-year part of the curve is where investors should be allocating to."

For more expert insight and the latest market action, click here to watch this full episode of Yahoo Finance Live.

Video transcript

BRAD SMITH: Yeah, Gargi, I was reading some of the key takeaways from your fall investment outlook, and particularly what struck my attention was the highest conviction trade, which continues to be fixed income. Why is that, and for how long could that continue to be the case?

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GARGI CHAUDHURY: Yeah, and I think it's important to specify where in fixed income, right? So right now, the entire piece that we've written is sort of focused on quality, so high quality fixed income. And then where in the duration part, so where in the interest rate sensitive portion of the yield curve do we think there's most bang for your buck?

And we think here that the belly of the curve, so think about the three to seven-year, really focusing in on that five-year part of the curve is where investors should be allocating to. Whether you want to do that with treasuries with an ETF ticker like IEI or the AG, whether you want to look at tips with something like TIP or even STIP or whether you want to own mortgages with MBB, all of that gives you access to that high quality and belly of the curve.

Where we want to still stay away from is what you and Seana were talking about with respect to the tenure or perhaps even longer. There isn't enough term premium built in yet. We think the longer end of the yield curve can still move higher. The yield curve can still steepen. But the belly, which is, again, that five-year point of the curve, is looking very attractive right now, especially if you think about the coupon income that you're generating.

So if you own the five-year point of just the Treasury-- you don't even have to look at spread products-- and if you own it for the next 12 years and rates go up by 100 basis points, you are still going to make money. Of course, if they go down by 100 basis points, you're going to make close to about double digits, so those are some really good asymmetries that we like here.

SEANA SMITH: Gargi, if we do see the US government shut down, if there is a deal that's not reached here on Capitol Hill within the next couple of days, how much risk does that then add to the market? Because Moody's coming out saying that, hey, if we do see the government shutdown, then that could potentially hurt the US's credit.

GARGI CHAUDHURY: Yeah, I mean, listen, we've already unfortunately had two rating agencies that have already downgraded the US. Obviously, a third one will certainly be news, but I don't to what extent the Treasury market or even the equity market is going to react any further. What I think we should all focus on is not so much about the known unknowns. I think, at this point, a government shutdown, if it does indeed happen, is sort of a known unknown.

But I spend a little bit more time thinking about the unknown unknowns really and what those could be as it pertains to both the equity and the bond markets. And I think with the government shutdown, as long as it's sort of a short period-- a shorter shutdown-- if you look at the history it's sort of averaged around 8 to 10 days-- of course there's going to be an impact to GDP for that 8 to 10 days period.

But that GDP does come back once the government reopens, so I think we have to keep that in mind. But what would be much more concerned around is how does earnings season play out? What should we be thinking about with respect to oil prices and the ramifications of higher USD on other parts of the world-- certainly the emerging market economies.