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Rate Hike in the Cards: How Will Bond ETFs React?

Sweta Killa

With the U.S. economy gaining traction lately on a solid job market and moderate inflation, the chances of an interest rates hike is pretty high. The market is anticipating the first rate hike in nearly a decade at the December 15–16 policy meeting.


If this happens and the Fed starts tightening, it will result in higher yields and lower bond prices as both yields and bond prices are inversely related to each other.


How Bonds React to Higher Rates?


The impact on prices is not the same for all bonds when rates rise. It primarily depends on duration and maturity. Duration is a measure of a fund’s sensitivity to a 1% change in interest rates. The longer the duration, the more sensitive the fund is to the changes in interest rates (read: Short-Term Bond Yields Rising: Timely ETF Bets).


This can be explained with the following example: consider a 10-year maturity investment grade corporate bond with duration of 8.4 years and coupon rate of 3.5%. If interest rates go up by 2% then the bond will lose 15% of its market value. On the other hand, the same investment grade corporate bond with duration of 14.5 years, maturity of 30 years and coupon rate of 4.5% will lose 26% of its value if interest rates are raised by 2%.


As a result, bonds having higher duration will experience significant losses when interest rates rise. Below, we have presented three ETFs that have a higher duration and are more vulnerable to an increase in interest rates.


PIMCO 25+ Year Zero Coupon U.S. Treasury Index ETF (ZROZ)


This ETF follows the BofA Merrill Lynch Long US Treasury Principal STRIPS index and holds 20 securities in its basket. Both effective maturity and effective duration are 27.28 years. The fund has accumulated $162.3 million in its asset base and trades in average daily volume of 44,000 shares a day. It charges 15 bps in annual fees and lost 0.7% over the past one month (read: Extended Duration ETFs Head to Head: EDV vs ZROZ).

 

Vanguard Extended Duration Treasury ETF (EDV)


This fund seeks to match the performance of the Barclays U.S. Treasury STRIPS 20–30 Year Equal Par Bond Index. The fund holds 73 bonds in total with effective maturity of 25.0 years and average duration of 24.6 years. Expense ratio came in at 0.12%. The product has amassed $368.6 million in its asset base while sees moderate volume of 51,000 shares per day on average. It lost 0.7% over the past one month.


iShares 20+ Year Treasury Bond ETF (TLT)


This is one of the most popular and liquid ETFs in the long-dated bond space with AUM of over $6.1 billion and average daily volume of more than 8.8 million shares. It tracks the Barclays Capital U.S. 20+ Year Treasury Bond Index, holdings 31 securities in its basket. The fund has average maturity of 26.51 years and effective duration of 17.23 years. It charges 15 bps in annual fees and was down 1.3% over the past one month.


Ultra-Short Bond ETFs


We also highlight three ultra-short bond ETFs with lower duration and interest rates’ risk. These funds offer investors greater protection against interest rate risk compared to the mid- and long-term counterparts.


SPDR Barclays 1-3 Month T-Bill ETF (BIL)


This product offers exposure to the short end of the yield curve by tacking the Barclays 1-3 Month U.S. Treasury Bill Index. It holds 10 securities in the basket with average maturity and effective duration of 0.09 years each. The fund has amassed $2.2 billion in its asset base while trades in solid volume of 1.5 million shares. It charges 14 bps in annual fees and delivered flat returns in the past one month (see: all the Government Bond ETFs here).

 

Guggenheim Enhanced Short Duration ETF (GSY)


This is an actively managed fund that seeks to maximize income by outperforming the Barclays Capital 1-3 Month U.S. Treasury Bill Index along with preservation of capital and daily liquidity. The fund charges 25 bps in annual fees and has amassed $504.6 million in its asset base. Volume is good as it exchanges about 152,000 shares a day on average. Holding 148 securities in its basket, the ETF has average duration of 0.17 years and average maturity of 1.03 years. GSY was relatively flat in last one-month period.


iShares Short Maturity Bond ETF (NEAR)


This actively managed ETF looks to maximize current income through diversified exposure to short-term bonds such as Treasuries, corporate bonds, asset-backed debt, and commercial mortgage-backed securities. The effective duration of the fund is 0.37 years while average maturity is 0.95 years. The product has accumulated $1.9 billion in AUM and trades in solid volume of 356,000 shares a day. It charges investors 25 bps in fees a year and added 0.14% in the past one month.


Conclusion


Given that not all bonds behave similarly to the increase in interest rates, investors should understand the impact of higher rates on bonds before investing in them. Notably, short-term bond ETFs are less impacted by higher interest rates.


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PIMCO-25Y ZERO (ZROZ): ETF Research Reports
 
VANGD-EX DUR TR (EDV): ETF Research Reports
 
ISHARS-20+YTB (TLT): ETF Research Reports
 
SPDR-BC 1-3M T (BIL): ETF Research Reports
 
GUGG-EN SH DUR (GSY): ETF Research Reports
 
ISHRS-ST MT BD (NEAR): ETF Research Reports
 
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