| Interest Rates and Bond Price Relationship | |
|---|---|
| Interest Rates Increase | Interest Rates Decrease |
| Yields on new bonds increase | Yields on new bonds decrease |
| Investors buy new bonds and sell existing ones | Investors want existing bonds and buy them |
| Existing bond prices fall | Existing bond prices rise |
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.
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 from a bond broker or through 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.
Bond ETF Special Considerations
Conventional wisdom holds that your investment strategy should become more conservative as you approach retirement or another important goal. In many cases, this means shifting more of a portfolio to bonds, which can offer a steady income stream and potentially less risk than stocks. When you buy an individual bond, it stipulates that the principal will be repaid at maturity, and you can design your bond purchases to mature at set intervals for income.
You might be drawn to ETFs that invest in bonds because bonds are generally safer investments. However, bond ETFs never mature—the ETF holdings must be adjusted to try and meet the fund's goals. Active management exposes your initial investment to greater levels of risk. Moreover, rising interest rates hurt the price of bond ETFs, with prices of the underlying (existing) bonds dipping as yields increase. If prices stay down, you may never recover your principal by the time you had planned to.
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.
What Is Negative About Bond ETFs?
Bond are used by many to preserve capital and create a source of income. Bond ETFs, during prolonged periods of rising rates, might cause you to lose a significant portion of your principal.
What Is the Largest Bond ETF in the US?
In August 2024, the largest bond ETF in the U.S. was the iShares Core U.S. Aggregate Bond ETF, which held $115 billion in net assets.
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.
