With the Federal Reserve largely expected to announce the start of rate normalization next week, the higher interest rates could cause bond exchange traded funds to underperform in the short-term.
When interest rates rise, the price of older bonds with lower rates fall. Since new bonds are issued at the newer and higher rates, investors would be less inclined to hold older debt securities with lower yields. Consequently, the less appealing older bonds will see prices fall.
For bond ETFs, investors should look at the duration, or a bond fund’s measure of sensitivity to changes in interest rates, so a higher duration means a higher sensitivity to shifts in rates.
For instance, the iShares 7-10 Year Treasury Bond ETF (NYSEArca: IEF) has a 7.64 year effective duration, which means that a 1% rise in interest rates could equate to about a 7.64% decline in the bond ETF’s price. In contrast, the iShares 20+ Year Treasury Bond ETF (NYSEArca: TLT) has a 17.40 year duration and could experience a 17.4% price decline if rates rose 1%. [Are Your Bond ETFs Optimized For Rising Rates?]
However, over a period of years, bond fund investors may find that their investments do better in an environment of higher interest rates than one in which rates hover near historically low levels, writes Daisey Maxey for the Wall Street Journal.
Bond funds have a duration indicator because the portfolios would buy and sell individual debt securities to maintain their target strategy. For instance, IEF would only hold Treasury bonds with a seven- to ten-year maturity.
Over longer investment periods as debt securities mature, bond funds will reinvest in newer issues with higher interest rates, and investors will enjoy the increased income generation.
“An initial rate increase could cause pain in the short term,” Joshua Barrickman, head of fixed-income indexing, Americas, at Vanguard Group, told the WSJ. “But over the long term, it will act to your benefit.”
In a hypothetical case where the Fed raises short-term rates by 0.25 percentage point in January and by a similar increments every other quarter through July 2019 for a total of 2 percentage points, the typical intermediate-term bond fund could lose 0.15% next year but generate positive yearly total returns thereafter, according to the Vanguard Group. Total returns include both the negative price change and income, so higher income generation may account for the positive total returns if bond prices fall in a rising rate environment.
However, if rates suddenly spiked, the funds would suffer steeper initial losses. The Fed, though, has repeatedly assured the markets that it will stick to gradual rate normalization.
“Intermediate-term bond-fund investors may feel a little sting, but it’s certainly not going to be a bleed-out,” Marilyn Cohen, chief executive at Envision Capital Management Inc., told the WSJ.
For more information on the fixed-income market, visit our bond ETFs category.
Max Chen contributed to this article.