The Upside of Bond ETFs’ Downside
September 17th, 2013 at 9:00am by Tom Lydon
Yields on 10-Year U.S. Treasuries have declined 2.8% in the past five days, but that drop barely dents the 56.3% year-to-date rise. Although the Federal Reserve has linked official rate hikes to U.S. employment data and promised to keep benchmark rates low for the foreseeable future, some bond investors have become jittery that a 30-year fixed income bull market is on the cusp of crashing to an end.
Bond prices and yields usually move inversely of each other, so the recent yield has caused significant capital destruction in fixed income portfolios, chasing investors to lower durations bonds and bond ETFs or out of debt instruments altogether. Duration is a measure of a bond’s sensitivity to changes in interest rates. The longer a bond’s duration or the duration on a bond ETF, the more vulnerable it or the fund is rising rates.
For example, the 30-year U.S. Treasury Bond with a duration of 20 will be about twice as sensitive to a change in yield as the 10-year U.S. Treasury Bond, which has a duration of 9. So, a 1% rise in the yield of the 30-year U.S. Treasury Bond could cause its value to decline by approximately 20%, whereas a similar increase in the yield of the 10-year U.S. Treasury Bond would cause a decline of about 9% in its value,” according to ProShares.
Still, some investors do not understand how rising rates can plague longer durations ETFs like the iShares 20+ Year Treasury ETF (NYSEArca: TLT). According to a survey released by Edward Jones last month, 63% of Americans don’t know how rising interest rates will impact investment portfolios such as 401(k)s, IRAs and other savings platforms. [Many Investors Don't Understand How Rising Rates Kill Bonds]