Demand for older, lower-yielding debt falls as yields on freshly issued debt rise. This lowers the price of existing bonds, resulting in the bond market’s aforementioned “bear market.”
This is a particularly risky position for bond ETF investors. A portfolio of bonds with comparable maturities is held by many bond ETFs. One of the most popular bond funds, the Vanguard Intermediate-Term Corporate Bond ETF (VCIT), includes bonds that mature in five to ten years. Vanguard sells bonds with a maturity of less than five years to maintain the portfolio’s duration. This means they’re compelled to offload assets at the shorter end of the yield curve on a regular basis while buying bonds at the longer end. This is known as interest-rate risk or yield-curve risk, and it will gradually depreciate the fund’s value in a rising-rate environment (which is still at least a year away).
How to Avoid Interest-Rate Risk
Investing in a shorter-duration bond fund, such as the Vanguard Short-Term Bond ETF, is one of the simplest methods to reduce interest-rate risk (BSV). BSV invests in bonds with maturities of one to five years, so it has a smaller interest-rate risk and is less vulnerable to interest-rate movements than an intermediate-term ETF like VCIT.
Of course, you have to give up something in exchange for this stability. The safer and shorter the duration of a bond, the lower the yield.
Another strategy to limit your interest-rate risk is to build a bond ladder, which will provide you with a steady source of income as benchmark rates rise.
How to Construct A Bond Ladder
By purchasing a series of bonds or bond funds with staggered maturity dates, you can create your own adjustable-rate income stream. The funds are then reinvested in a new security at the top of the ladder, which becomes your new longest-dated security, as each security matures. If interest rates rise, new investments will have higher coupon rates than those at the bottom of the ladder, resulting in a progressive increase in your yield.
While longer-term bonds have a higher yield, shorter-term fixed income investments have a lower risk of interest rate changes. In other words, if you expect interest rates to rise soon, you’ll want your longest-dated bond to mature soon (probably within five years) so you’re not trapped with a bunch of relatively low-yield fixed income investments for an extended period of time.
The most critical aspect of building a bond ladder that will protect your wealth and work in a rising rate scenario is that you only buy individual bonds or bond funds with a specified maturity. Bond funds with maturity dates, unlike traditional bond funds, hold bonds that mature in a specified year and dissolve and distribute their assets to investors at the end of that year, much like a conventional bond.
The Best Bond ETFs
The PowerShares BulletShares funds from Invesco are bond ETFs with a ten-year maturity. Each year, Invesco offers both an investment-grade and a high-yield fund, allowing you to balance safety and return by selecting one or the other, or by combining the two in your bond ladder.
Whatever funds you choose, you may maintain your bond ladder intact by reinvesting the redemption value into a new security at the top of the ladder when the first maturity in your ladder approaches. This will keep your revenue stream going, and it will expand over time as rates rise again (maybe in the following 12 to 24 months?).
When interest rates climb, do bond ETFs rise as well?
- ETFs that invest in short-term bonds. This bond ETF invests in short-term bonds with maturities of less than a few years. These bonds don’t fluctuate significantly in response to interest rate fluctuations, which helps to reduce risk.
- ETFs that invest in intermediate-term bonds. This bond ETF invests in intermediate-term bonds, which typically have a maturity of a few years to ten years. This ETF gives a higher yield than short-term bond ETFs and can vary a lot in response to interest rate swings.
- ETFs that invest in long-term bonds. This bond ETF invests in long-term bonds having maturities of 30 years or more. These bonds often pay a greater interest rate than shorter-term bonds due to their longer tenure. This type of bond reacts quickly to interest rate changes, rising when rates fall and falling when rates rise.
- ETFs that track the entire bond market. This bond ETF provides investors with exposure to bonds with short, middle, and long maturities. It offers broad, diversified bond exposure without being overly skewed in one side or the other.
- ETFs that invest in investment-grade bonds. This type of bond ETF invests solely in highly rated bonds, making it a safer option. This bond ETF pays less than ETFs containing lower-quality assets, such as high-yield bonds, because to the perceived safety of these bonds.
- ETFs that invest in high-yield bonds. This bond ETF invests on high-yield bonds, sometimes known as trash bonds in the past. The quality of the bonds in this type of ETF can range from good to bad, depending on the issuer. This ETF often provides a higher yield than investment-grade ETFs due to the perceived riskiness of its bonds.
- Municipal bond exchange-traded funds (ETFs). This bond ETF invests in securities issued by states and localities, most of which are tax-advantaged bonds. These ETFs will save you money on federal taxes, but they will only save you money on state taxes if they invest primarily in states where you pay taxes.
When interest rates fall, do bond ETFs rise?
The closer a bond’s maturity date approaches, the more vulnerable it is to rate increases. When all other factors are equal, a 10-year bond has a higher interest rate risk than a five-year bond since your money is exposed to rising interest rates for a longer length of time.
A time-weighted measure of interest-rate risk is called duration. Duration predicts how a bond’s price will fluctuate in reaction to interest rate fluctuations. More interest-rate risk is associated with longer periods. A duration of 3.5, for example, suggests that if interest rates rise by 1%, the value of a bond will fall by 3.5 percent.
- The duration is a guess, not a guarantee. Bond prices rise when interest rates fall, but this isn’t a one-to-one relationship. Price increases from dropping rates are undervalued by duration, whereas price declines from rising yields are overestimated.
- Duration is based on a simplified interest-rate scenario. When interest rates move by 1% across all maturities, duration is calculated; in other words, when rates change, the entire yield curve shifts by 1% up or down. It’s rare that reality is so exact.
Bond ETFs typically pay out income on a monthly basis. One of the most appealing features of bonds is that they pay interest to investors on a regular basis, usually every six months. Bond ETFs, on the other hand, hold a variety of issues at once, and some of the bonds in the portfolio may be paying their coupons at any one time. As a result, bond ETFs often make monthly rather than semiannual coupon payments. This payment’s amount varies from month to month.
Traditional bond indexes are excellent benchmarks but poor portfolio builders. The majority of equities ETFs hold all of the securities in their index. However, with bonds, this is usually not achievable. Hundreds, if not thousands, of individual securities are frequently included in bond indexes. It’s not only tough, but also expensive to buy all those bonds for an ETF’s portfolio. Even if the purchase of thousands of bonds in illiquid markets has a minor impact on the index, the cost of doing so can significantly erode returns.
Managers of bond ETFs frequently tweak their indexes. To keep expenses down, fund managers must often pick and select which bonds from the bond index to include in the ETF. They’ll choose bonds that, based on credit quality, exposure, correlations, duration, and risk, provide the best representative sample of the index. The term “optimization” or “sampling” refers to this process.
Optimizing saves money, but it comes with its own set of hazards. Over time, an ETF’s returns may diverge from those of its index, depending on how aggressively its portfolio was optimized. The majority of ETFs closely track their underlying indexes; nevertheless, a few have fallen short of their benchmark by a few percentage points or more per year. (For further information, see “How To Run An Index Fund: Full Replication vs. Optimization.”)
Individual bond values are difficult to estimate. There is no one agreed-upon price for the value of every bond without an official exchange. Many bonds, in reality, do not trade on a daily basis; particular forms of municipal bonds, for example, can go weeks or months without trading.
To calculate NAV, fund managers need precise bond prices. Bond pricing services, which estimate the value of individual bonds based on recorded trades, trading desk surveys, matrix models, and other factors, are used by both mutual fund and ETF managers. Of course, nothing is certain. But it’s a reasonable guess.
The share price of an ETF isn’t the same as its NAV. The share price of a bond mutual fund is always the same as its net asset value, or the value of the underlying assets in the portfolio. The share price of a bond ETF, on the other hand, can fluctuate depending on market supply and demand. When share prices rise above NAV, premiums form, and when prices fall below NAV, discounts form. However, there is a natural mechanism in place to maintain the share price and NAV of a bond ETF in sync: arbitrage.
Arbitrage is used by APs to keep ETF share prices and NAV in sync. Authorized participants (APs), a unique class of institutional investors, have the right to create or destroy shares of the ETF at any moment. If an ETF’s share price falls below its NAV, APs can profit from the difference by purchasing ETF shares on the open market and trading them into the issuer in exchange for a “in kind” exchange of the underlying bonds. The AP only needs to liquidate the bonds in order to profit. Similarly, if the share price of an ETF increases above NAV, APs can buy individual bonds and exchange them for ETF shares. Arbitrage produces natural purchasing or selling pressure, which helps keep the share price and NAV of an ETF from drifting too far apart.
An ETF’s price may be significantly below its declared NAV in stressed or illiquid markets, or for an extended length of time. When this happens, it simply signifies that the ETF industry believes the bond pricing service is incorrect, and that the prices for the fund’s underlying bonds are being overestimated. In other words, the APs don’t think they’ll be able to sell the underlying bonds for their stated valuations. This means that the ETF price falls below its NAV, which is good news for ETF investors. (Any premiums that may accrue follow the same procedure.)
Large premiums and discounts in a bond ETF don’t always indicate mispricing. Highly liquid bond ETFs can perform price discovery for the bonds they hold, and an ETF’s market price can actually be a better approximation of the aggregate value of the underlying bonds than its own NAV.
When interest rates rise, what happens to bond index funds?
Interest rates are rising after previously hovering at their lowest levels in 40 years. Bond prices rise when yields fall, and bond prices will fall when yields (interest rates) rise.
No, interest rate increases do not affect all bonds in the same way. In general, the longer the bond’s term, such as a ten-year bond versus a two-year bond, the more it is affected by changing interest rates. If interest rates rise, a ten-year bond will typically lose more value than a two-year note. In addition, the lower the “coupon” rate on a bond, the more sensitive the bond’s price is to interest rate movements. Other factors can also have an impact. A variable rate bond, for example, is unlikely to lose as much value as a fixed rate asset.
As interest rates climb, what should I do? Is it better to keep my bonds or sell them?
Rising interest rates have little influence on the income you receive if you buy a bond and hold it until it matures, as many investors do. You just redeem your maturing bond and receive par, or the bond’s face value. Meanwhile, you will continue to collect or accrue interest at the rate that you anticipated when you purchased the bond. Bloomberg, LP presented the following example:
If interest rates rise and you need to sell your bonds before they mature, keep in mind that their value may have fallen and you may have to sell them at a loss. It’s important to remember that bond prices fluctuate in the opposite direction of yield. Bloomberg, LP has presented another example:
If interest rates have fallen since you purchased your bonds, the value of your bonds will have increased, resulting in a “capital gain.” This is due to the fact that your bond is more valuable. Here’s another example of how Bloomberg data might be used:
Because a bond fund’s total return isn’t tied to a fixed maturity date, the fund’s total return is likely to decline. The total return includes both price changes and interest rate payments. If interest rates rise, the value of the bond portfolio owned by the fund will fall, reducing overall return. The fund, on the other hand, will continue to receive interest payments from the bonds it owns and will distribute them to investors on a regular basis, preserving the current yield. Investors in bond funds also benefit from competent management and asset diversification.
Yes, practically all investments come with the possibility of losing some or all of your money. When investing in bonds that aren’t government-guaranteed, keep in mind that the return on an investment is determined by its credit as well as market fluctuations. The greater the profit, the greater the risk. Investing in reasonably safe assets, on the other hand, yields lower returns. Bonds range from U.S. Treasury securities, which are backed by the government’s full faith and credit and are credit risk-free, to bonds that are below investment grade and deemed speculative. “What will I do if my investment isn’t there when I need it?” is a good question to ask yourself when considering your risk tolerance.
Most personal financial counselors advise investors to keep a diverse investment portfolio that includes bonds, equities, and cash in varied amounts, based on their circumstances and goals. You must be mindful of the dangers of rising interest rates, especially today. If you plan to buy bonds and hold them until they mature, they will provide a consistent stream of payments and principal payback. Many people buy bonds to protect and grow their money or to earn consistent interest payments. Bonds can help you achieve any of your investment goals, whether it’s saving for your children’s college education or a new home, increasing retirement income, or any of a number of other worthwhile financial goals.
Bond ETFs: Can They Lose Money?
- Market transparency is lacking. Bonds are traded over-the-counter (OTC), which means they are not traded on a single exchange and have no official agreed-upon price. The market is complicated, and investors may find that different brokers offer vastly different prices for the same bond.
- High profit margins. Broker markups on bond prices can be significant, especially for smaller investors; according to one US government research, municipal bond markups can reach 2.5 percent. The cost of investing in individual bonds can quickly pile up due to markups, bid/ask gaps, and the price of the bonds themselves.
- Liquidity issues. Liquidity of bonds varies greatly. Some bonds are traded daily, while others are traded weekly or even monthly, and this is when markets are at their best. During times of market turmoil, some bonds may cease to trade entirely.
A bond ETF is a bond investment in the form of a stock. A bond ETF attempts to replicate the performance of a bond index. Despite the fact that these securities only contain bonds, they trade on an exchange like stocks, giving them some appealing equity-like characteristics.
Bonds and bond ETFs may have the same underlying investments, however bond ETFs’ behavior is affected by exchange trading in numerous ways:
- Bond ETFs do not have a maturity date. Individual bonds have a definite, unchanging maturity date when investors receive their money back; each day invested brings that day closer. Bond ETFs, on the other hand, maintain a constant maturity, which is the weighted average of all the bonds in the portfolio’s maturities. Some of these bonds may be expiring or leaving the age range that a bond ETF is targeting at any given time (e.g., a one- to three-year Treasury bond ETF kicks out all bonds with less than 12 months to maturity). As a result, fresh bonds are regularly purchased and sold in order to maintain the portfolio’s maturity.
- Even in illiquid markets, bond ETFs are liquid. Single bonds have a wide range of tradability. Some issues are traded on a daily basis, while others are only traded once a month. They may not trade at all during times of stress. Bond ETFs, on the other hand, trade on an exchange, which means they can be purchased and sold at any time during market hours, even if the underlying bonds aren’t trading.
This has real-world ramifications. According to one source, high-yield corporate bonds trade on less than half of the days each month, but the iShares iBoxx $ High Yield Corporate Bond ETF (HYG | B-64) trades millions of shares per day.
- Bond ETFs pay a monthly dividend. One of the most appealing features of bonds is that they pay out interest to investors on a regular basis. These coupon payments are usually made every six months. Bond ETFs, on the other hand, hold a variety of issues at once, and some of the bonds in the portfolio may be paying their coupons at any one time. As a result, bond ETFs often pay interest monthly rather than semiannually, and the amount paid can fluctuate from month to month.
- Diversification. You may own hundreds, even thousands, of bonds in an index with an ETF for a fraction of the cost of buying each issue individually. At retail prices, it’s institutional-style diversification.
- Trading convenience. There’s no need to sift through the murky OTC markets to argue over rates. With the click of a button, you may purchase and sell bond ETFs from your regular brokerage account.
- Bond ETFs can be bought and sold at any time during the trading day, even in foreign or smaller markets where individual securities may trade infrequently.
- Transparency in pricing. There’s no need to guess how much your bond ETF is worth because ETF values are published openly on the market and updated every 15 seconds during the trading day.
- More consistent revenue. Instead of six-monthly coupon payments, bond ETFs often pay interest monthly. Monthly payments provide bond ETF holders with a more consistent income stream to spend or reinvest, even if the value varies from month to month.
- There’s no assurance that you’ll get your money back. Bond ETFs never mature, so they can’t provide the same level of security for your initial investment as actual bonds may. To put it another way, there’s no guarantee that you’ll get your money back at some point in the future.
Some ETF providers, however, have recently began creating ETFs with defined maturity dates, which hold each bond until it expires and then disperse the proceeds once all bonds have matured. Under its BulletShares brand, Guggenheim offers 16 investment-grade and high-yield corporate bond target-maturity-date ETFs with maturities ranging from 2017 to 2018; iShares offers six target-maturity-date municipal ETFs. (See “I Love BulletShares ETFs” for more information.)
- If interest rates rise, you may lose money. Rates of interest fluctuate throughout time. Bonds’ value may fall as a result of this, and selling them could result in a loss on your initial investment. Individual bonds allow you to reduce risk by simply holding on to them until they mature, at which point you will be paid their full face value. However, because bond ETFs don’t mature, there’s little you can do to avoid the pain of rising rates.
Individual bonds are out of reach for the majority of investors. Even if it weren’t, bond ETFs provide a level of diversification, liquidity, and price transparency that single bonds can’t match, plus intraday tradability and more regular income payouts. Bond ETFs may come with some added risks, but for the ordinary investor, they’re arguably a better and more accessible option.
When interest rates are low, should I buy bonds?
- Bonds are debt instruments issued by corporations, governments, municipalities, and other entities; they have a lower risk and return profile than stocks.
- Bonds may become less appealing to investors in low-interest rate settings than other asset classes.
- Bonds, particularly government-backed bonds, have lower yields than equities, but they are more steady and reliable over time, which makes them desirable to certain investors.
When interest rates fall, what happens to bonds?
When interest rates fluctuate in absolute terms, interest rate risk occurs. The value of fixed income assets is directly affected by interest rate risk. Due to the inverse relationship between interest rates and bond prices, the risk associated with a rise in interest rates leads bond prices to fall, and vice versa.
Interest rate risk impacts bond prices, and all bondholders are exposed to it. It’s vital to remember, as previously said, that as interest rates climb, bond prices decline. When interest rates rise and new bonds with greater yields than older securities are offered in the market, investors are more likely to purchase the new bond issues in order to benefit from the higher returns.
As a result, older bonds based on earlier interest rate levels have less value, and as a result, investors and traders sell their old bonds, lowering their values.
Bond prices, on the other hand, tend to rise when interest rates decline. Investors are less inclined to purchase new bonds as interest rates fall and new bonds with lower yields than older fixed-income instruments are launched in the market. As a result, the price of older bonds with greater yields tends to rise.
Consider the following scenario: the Federal Open Market Committee (FOMC) meets next Wednesday, and many traders and investors believe interest rates will rise in the coming year. The FOMC decides to hike interest rates in three months after the meeting. As a result, bond prices fall as new bonds with greater yields are issued in three months.
When is the best time to buy a bond?
It’s better to buy bonds when interest rates are high and peaking if your goal is to improve overall return and “you have some flexibility in either how much you invest or when you may invest.” “Rising interest rates can potentially be a tailwind” for long-term bond fund investors, according to Barrickman.
What happens when the yield on a bond rises?
- A bond’s return isn’t just determined by its price. Rising yields might result in short-term capital losses, but they can also pave the way for higher future profits.
- The portfolio generates more income over time than it would have if interest rates remained low.
Bonds are significant in the realm of investing. They provide your portfolio with income, stability, and diversification. Bond investors, on the other hand, are frequently concerned about rising yields (the total income a bond pays each year). Why?
Rising interest rates have an impact on bond prices since they frequently increase yields. Rising yields, on the other hand, can cause a short-term reduction in the value of your existing bonds. This is because investors will prefer to purchase bonds with a higher yield. As demand for lower-yielding bonds declines, the value of those bonds will certainly decline as well.
Why do bond yields rise?
Face value, coupon, maturity, issuer, and yield are all elements that influence the price of a bond.
The level of prevailing interest rates in the economy, however, has a greater impact on a bond than any other element. When interest rates rise, bond prices fall, raising the yield on older bonds and putting them in line with newer bonds with greater coupons.
When interest rates fall, bond prices rise, lowering the return on older bonds and putting them in line with newer bonds with lower coupons.
Is bond investing a wise idea in 2021?
Because the Federal Reserve reduced interest rates in reaction to the 2020 economic crisis and the following recession, bond interest rates were extremely low in 2021. If investors expect interest rates will climb in the next several years, they may choose to invest in bonds with short maturities.
A two-year Treasury bill, for example, pays a set interest rate and returns the principle invested in two years. If interest rates rise in 2023, the investor could reinvest the principle in a higher-rate bond at that time. If the same investor bought a 10-year Treasury note in 2021 and interest rates rose in the following years, the investor would miss out on the higher interest rates since they would be trapped with the lower-rate Treasury note. Investors can always sell a Treasury bond before it matures; however, there may be a gain or loss, meaning you may not receive your entire initial investment back.
Also, think about your risk tolerance. Investors frequently purchase Treasury bonds, notes, and shorter-term Treasury bills for their safety. If you believe that the broader markets are too hazardous and that your goal is to safeguard your wealth, despite the current low interest rates, you can choose a Treasury security. Treasury yields have been declining for several months, as shown in the graph below.
Bond investments, despite their low returns, can provide stability in the face of a turbulent equity portfolio. Whether or not you should buy a Treasury security is primarily determined by your risk appetite, time horizon, and financial objectives. When deciding whether to buy a bond or other investments, please seek the advice of a financial counselor or financial planner.