Bond ETFs (Exchange-Traded Funds) are versatile investment vehicles, and for good reason. Diversified bond ETFs comprise an array of bonds varying from short-term to long-term maturity periods and spanning different types, such as government and corporate bonds. Among the various types of bond ETFs available, those focusing on long-term government bonds are often considered a stable and secure choice.
However, the fixed-income landscape isn’t static; it is heavily influenced by various macroeconomic factors, one of the most crucial being interest rates. Let us discuss the impact of rising interest rates on long-term bond ETFs, explaining why an increase in rates often spells bad news for these funds.
Relationship between bond price and interest rate
An inverse relationship exists between bond prices and interest rates. As interest rates rise, the price of existing bonds tends to fall. The reason is simple: newly issued bonds will carry higher yields (interest rate income as a percentage of the bond market price), making existing bonds with lower yields less attractive. This drop in demand leads to a decrease in the price of existing bonds.
The present value of a bond’s future cash flows (interest and principal repayments) is calculated using the current interest rate. When interest rates rise, the discount rate used to calculate the present value of these future cash flows increases, which results in a lower present value and, thus, a lower price for the bond.
To elaborate, investors who can get a higher yield from newly issued bonds are unlikely to pay the same price for older bonds that pay a lower yield. These investors would want a discount on the older bonds to equate the yields, which effectively lowers the price of these existing bonds. So, the price of a bond ETF, which comprises these existing bonds, decreases with the rise in interest rates.
Adding to this dynamic is the role played by the financial market in reacting to expectations. Financial markets are forward-looking. If the market broadly expects interest rates to rise, investors might start selling bonds in anticipation, driving their prices down even before the interest rate change actually occurs. This sentiment-driven market behaviour can exacerbate the impact of rising interest rates on bond ETFs heavy on long-term bonds.
It’s also worth noting that the yield generated by the bond ETF may increase over time as the ETF acquires new bonds with higher yields. However, this may or may not compensate for the decline in the ETF’s Net Asset Value (NAV) due to the falling prices of underlying bonds.
Relationship between bond term and interest rate
The sensitivity of bond prices to changes in interest rate is greater for long-term bonds than short-term ones. Long-term bonds have longer durations to receive the cash flows from those bonds, making them more sensitive to interest rate changes. When interest rates rise, the price of a long-term bond can fall much more than a short-term bond.
The intricate composition of many bond ETFs — featuring short-term, long-term, government bonds, and corporate bonds — offers both a buffer and exposure to various market conditions. While this diversity is beneficial, predicting how the ETF will react to macroeconomic changes like interest rate fluctuations becomes more intricate. Investors need to understand the specific composition of their chosen bond ETF to anticipate its performance better and, where required, to adapt their investment strategy accordingly.
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- Introduction to bond maturity period
- An introduction to bond ratings
- An introduction to risk-free bonds and risk-free rate
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