Interest rate changes are the primary culprit when bond exchange-traded funds (ETFs) lose value. As interest rates rise, the prices of existing bonds fall, which impacts the value of the ETFs holding these assets.
Let’s look at why bond ETFs drop in value and consider how you might avoid any negative effects on your portfolio.
Key Takeaways
- The share prices of exchange-traded funds (ETFs) that invest in bonds typically go lower when interest rates rise.
- When market interest rates rise, the fixed rate paid by existing bonds becomes less attractive, sinking these bonds’ prices.
- Rather than selling assets at depressed prices, bond ETF investors might benefit from waiting for a potential recovery as interest rates return to their previous level.
Advantages and Disadvantages of Bond ETFs
Conventional wisdom holds that your investment strategy should become more conservative as you approach retirement or another important goal. This probably means shifting more of your portfolio to bonds, which can offer a steady income stream and potentially less risk than stocks. When doing so, you might be drawn to ETFs that invest in bonds because they have access to an instantly diversified portfolio of fixed-income assets.
Although the advantages of bond ETFs can make them a valuable part of a conservative portfolio, they have their drawbacks. When you buy an individual bond, it stipulates that the principal will be repaid at maturity. But bond ETFs never mature, which exposes your initial investment to greater levels of risk. Moreover, rising interest rates hurt the price of bond ETFs, with prices of the underlying bonds dipping as yields increase.
Suppose you’re considering bond ETFs as a lower-risk investment and counting on them to maintain their value over the near term. In that case, price declines are more than inconvenient since they might threaten your chances of retirement or meeting your financial goals.
How Bond ETFs Work
A bond ETF is a pooled investment security tied to a portfolio of bonds. Bond ETFs expose investors to various fixed-income assets with a specified holding period and strategy, such as investing in U.S. Treasurys or high-yield corporate bonds. Like other ETFs, bond ETFs trade throughout the day on the major stock exchanges.
Trading on a centralized exchange makes bond ETFs significantly more liquid than individual bonds, which must be bought over the counter from a bond broker, or bond mutual funds, and they change hands only once daily. This flexibility can be helpful when turmoil hits the bond market, since you can trade bond ETFs even when the fixed-income markets experience distress.
As a bond ETF investor, you get income through regular (usually monthly) dividend payouts. Bond ETFs also pay any capital gains as an annual dividend. Although these capital gains payouts may increase your tax bill, the effect is generally minimal, as bond returns don’t generate capital gains in the same way as stock investments.
Bond ETF Yields
For bonds, yield refers to the percentage return that an investor should expect to make. In technical terms, a bond’s yield is the relationship between its coupon—or the interest it pays out—and its current market value. When a bond’s price goes down, its yield goes up, while a drop in yield means higher bond prices.
While the yield of an individual bond is relatively straightforward, bond ETFs are more complex. Since these investments represent a portfolio of many different bonds, it can be difficult to understand a bond ETF’s overall yield. But there are some approaches to doing so.
One common measure is the average yield to maturity: Take the weighted average yield of the bonds in the portfolio, and assume that the assets are held until maturity. However, this might not align with the practices of particular bond ETFs, which often sell bonds before they mature, and it doesn’t account for the expenses charged by the ETF.
Other alternatives include determining a bond ETF’s Securities and Exchange Commission (SEC) 30-day yield and representing the dividend and interest payouts over the past month after subtracting expenses. You can also calculate a bond ETF’s yield by dividing recent distributions over its net asset value, or you can look at the 12-month yield to quantify an ETF’s real-world behavior for the past year.
These measures frequently give you different results, so it could be useful to consider several of them together when looking at the yield of a bond ETF, especially if you’re using these calculations to compare funds and make investment decisions.
The yield you can expect to earn from a bond ETF depends on the type of bonds in the fund’s portfolio. Corporate bonds tend to pay higher yields because they present greater risk, while yields are lower for less risky government bonds.
Why Do Bond ETF Values Drop?
When you buy an individual bond, you invest, understanding that the principal will be repaid in full when the bond reaches maturity. Bond ETFs, however, hold assets with different maturity dates and buy and sell bonds as they expire or no longer match the age range that the fund targets. This means that bond ETFs do not have the same principal repayment guarantee as individual bonds.
Fluctuations in the prices of bond ETFs often stem from the inverse relationship between the bond market and interest rates. Bond prices and yields moving in the opposite direction may seem counterintuitive, but the equation is simple enough. When prevailing interest rates rise, the fixed rate paid by an existing bond becomes less attractive, lowering its price. Conversely, falling interest rates make an existing bond’s payouts more attractive, boosting its price.
Since bond ETFs own a basket of fixed-income investments, they are not immune to interest rate risk. Increasing interest rates put downward pressure on the prices of bond ETFs, which can exasperate investors who turned to these assets, hoping to preserve their capital while generating a stream of income.
The Federal Reserve’s sustained campaign of interest rate hikes in 2022 and 2023 negatively affected the price performance of bond ETFs.
What to Do When Bond ETFs Go Down
If you own shares of a bond ETF, you might have a sinking feeling seeing the market value of your investment dip as interest rates increase. However, it’s worth noting that rising interest rates can’t last forever, and bond ETF prices are likely to recover once rates go lower.
While the ability to trade shares in them easily is part of what makes bond ETFs attractive, you may want to avoid selling these assets at a depleted price. If you can wait for a different stage of the interest rate cycle, you might see a recovery in the prices of bonds and the ETFs that hold them.
Similarly, when higher interest rates lower share prices in bond ETFs, the market typically presents other income-generating opportunities. Lower bond ETF prices may coincide with higher yields on cash investments such as money market accounts (MMAs), certificates of deposit (CDs), and high-yield savings accounts.
A decrease in bond ETF prices is not a reason to sell in a panic, and it could be an opportunity to assess how your strategy matches up with the present economic cycle. The relative attractiveness of bond ETFs and other investments shifts in response to changing conditions, and it’s up to you to ensure that you’re maximizing your yield while taking on an acceptable level of risk.
Why Do Bond ETFs Go Down When Interest Rates Rise?
When interest rates increase, the price of bonds—and the ETFs that invest in bonds—moves lower. This inverse relationship occurs because the fixed rate paid by an existing bond becomes less favorable as the market interest rate increases.
Are Bond ETFs a Good Investment?
Like all investments, bond ETFs have their pros and cons. Tradable on stock exchanges and accessible to retail investors, bond ETFs represent an easy way to invest in a diversified portfolio in a general or specific bond market segment.
However, it’s important to check the expense ratio of bond ETFs. In addition, rising interest rates can send bond ETF prices lower, exposing investors to losses. Investors may benefit from holding bond ETFs longer to wait out such dips.
Do Bond ETFs Pay Out Interest?
Bond ETFs pay out interest income to their shareholders in the form of dividends, typically monthly. The amount that shareholders receive may vary from month to month.
What Is the Average Return of a Bond ETF?
Different types of bond ETFs have distinct risks and returns. Total bond market ETFs, which include assets from across the fixed-income market, have one-year returns of 3.37%, according to VettaFi.
The Bottom Line
Changes in interest rates can have a significant effect on bond ETFs and other fixed-income investments. Increasing interest rates tend to make bonds and bond ETFs tumble.
For this reason, bond ETFs may be more appropriate for those who can tolerate the interest rate risk and hold the asset over a long period, particularly if you need to wait for a shift in the interest rate environment.
