Help Me Understand Interest Rate Risk With ETF Bond Index Funds

[l2jperry]

Hey guys,

I'm hoping someone with a little more investment knowledge can clarify if my thinking on this is correct:

For the most part (save for high-yield bonds) when interest rates rise bonds become worth less. However, if you hold an ETF Bond Index Fund, say either a Muni Fund or Long Term Corporate Bond Fund, won't the interest rate risk be less since the ETF is I assume always buying new bonds when the older bonds mature?

Thanks for your help, still getting a handle on all this investment stuff :).

[Huskie87]

Nope, any investment which carries a stream of set payments into the future has interest rate risk.  A fund (ETF or mutual fund) essentially holds many different bonds, each with their own duration (interest rate risk).  As interest rates rise, those bonds prices fall depending on their duration.   

If an individual bond has a duration of 5, and a bond etf has a duration of 5, we would expect both to fall 5% if interest rates suddenly rose by 1% across all maturities.

[l2jperry]

Nope, any investment which carries a stream of set payments into the future has interest rate risk.  A fund (ETF or mutual fund) essentially holds many different bonds, each with their own duration (interest rate risk).  As interest rates rise, those bonds prices fall depending on their duration.   

If an individual bond has a duration of 5, and a bond etf has a duration of 5, we would expect both to fall 5% if interest rates suddenly rose by 1% across all maturities.

Interesting, thank-you for the input. Is it correct then to assume the following:

1.) A Bond ETF index fund is buying new bonds with higher interest rates (as the rates rise) as the older ones mature?
2.) If the above is true, doesn't that make a Bond ETF index fund somewhat less susceptible to interest rate risk than say buying one Bond?

[Huskie87]

I understand what you're getting at, but for the most part the answer is no.  BND for example has a duration of 5.73 and an average maturity of 8 years.  If you find a bond with similar yield, duration and maturity...your experience will be roughly the same in BND as it would be with that particular individual bond.

The reason why is because BND's duration of 5.73 incorporates both the bonds that are about to mature, like you alluded to, but also other bonds that have much higher durations and longer maturities.  So if rates rise, yes you'll get the advantage of reinvesting those soon-to-mature bonds at a higher yield, but you'll also have those longer maturity bonds with higher durations that will offset those soon-to-mature bonds.

However, the etf or mutual fund gives you the added value of diversification into many different bonds, which reduces your credit risk (chance of default).

[Heckler]

There are several great articles here.

http://canadiancouchpotato.com/category/bonds/

[NoStacheOhio]

I think there's still an advantage here using mutual funds or ETFs to hold bonds in that you would spend a fair bit of time/effort to set up and maintain a diversified bond ladder equivalent, no?