Target Date Bond ETFs Reduce Rate Risk | ETF Trends

In anticipation of a rising interest rate environment, fixed-income investors have begun shifting down the yield curve. However, a number of target-date exchange traded funds provide an alternative option for those who are in for the long haul.

In a rising interest rate environment, bonds with a fixed lower rate are less desirable than a newly issued bond with the higher rate, so pre-existing zero-coupon bonds would see prices decline enough to match the same prevailing returns on the higher interest rates. Consequently, most investors would sell older bonds at a loss in order to reinvest in higher yielding securities.

Larger bond ETFs typically hold a basket of bond securities with varying maturities and re-allocates once a bond matures. Many ETFs come with an effective or average duration that measures the fund’s sensitivity to changes in interest rates. For example, if a hypothetical ETF has a 3 year effective duration, the fund would see its price dip 3% if interest rates were to rise 1%.

However, investors can also hold onto individual bonds until maturity to avoid realizing a short-term loss as they would regain the initial principal once the security matures plus interest payments. This is where target-date ETFs come into play.

Target-maturity ETFs only hold bonds that mature in a set year and distributes cash back to investors upon maturity. With target-maturity bond ETFs, investors can implement a type of bond ladder strategy that has evenly spaced out maturity dates to help minimize interest rate risk. Essentially, target-date bonds appeal to buy-and-hold investors who want a steady stream of income without the risk of losing their initial principal.