The True Risk of Bond ETFs

In coming up with ways to protect their portfolios, many investors draw on lessons learned from their most recent mistakes. Unfortunately, most people right now are taking the lessons they learned from the 2008 bear market and buying bonds, which could easily prove to be far riskier than they thought.

The classic seesaw
With occasional exceptions, the historical relationship between stocks and bonds has largely held true for decades, and it's still true today. Typically, stock prices and bond prices move in opposite directions, as investors alternate trading the prospects of greater returns from riskier assets against the desire for safety and capital preservation. That relationship actually works well for those who maintain a diversified portfolio, as it ensures that even when one type of asset is doing the poorly, the other usually does fairly well to offset some of the losses.

But with so much money moving into the bond market, rates on even the longest-term bonds have fallen to historically low levels. That has created some impressive gains for those who got into bonds early on, but has also increased the risk for those who continue to hold bonds.

Understanding duration
When bond rates are low, the biggest risk is interest rate risk. The key to rate risk is figuring out how much the price of an individual bond or bond fund will drop for every percentage point that overall rates rise.

You can find a simple answer to this question by looking at the duration of the bond or fund in question. In simple terms, duration measures how quickly bondholders get their money back, considering both interest payments and the principal payment you receive at maturity. One simple rule of thumb is that for every year of duration, the bond or fund will lose one percentage point of value for every percentage point increase in rates. So while a fund with a duration of one year would suffer only a 1% loss if rates rise by a percentage point, a fund with a duration of 10 years could lose 10% of its value.

With that in mind, let's look at some of the duration figures for the most popular bond exchange-traded funds:

ETF

Duration (Years)

Current Yield

Breakeven Point (Years)

iShares Barclays TIPS Bond (NYSE: TIP  )

3.5

3.32%*

1.1

iShares US Treasury 20+ Year (NYSE: TLT  )

15.7

3.48%

4.5

Vanguard Total Bond Market (NYSE: BND  )

4.4

3.62%

1.2

iShares US Treasury 7-10 Year (NYSE: IEF  )

7.3

2.98%

2.4

SPDR Barclays High Yield Bond (NYSE: JNK  )

4.7

10.68%

0.4

iShares Investment Grade Corporate (NYSE: LQD  )

7.3

4.90%

1.5

iShares US Treasury 1-3 Year (NYSE: SHY  )

1.9

1.18%

1.6

Source: Morningstar, author calculations.
Breakeven point refers to length of interest payments needed to offset losses from a one-percentage-point rise in interest rates.
* Includes gain from inflation adjustment.

To put this in perspective, keep in mind that interest rates have fallen over a percentage point in just the past few months. Investors have based that precipitous drop largely on the prospects for a severe double-dip recession and fears of a long period of stagnation similar to what Japan has suffered through since 1990.

What that indicates is that if the worst-case scenario doesn't happen, interest rates could rebound very quickly if the economy starts firing again. The speed with which those rate rises could create losses similar to what Treasuries saw in 2009, when the stock market rally encouraged investors to take money out of bonds. And the resulting losses could take years for you to recover through receiving interest payments -- especially since most bond ETFs aren't paying you much of a yield right now.

Know the risk
None of this is to say that you shouldn't have any of your money in bonds right now. Sticking to a reasonable asset allocation strategy makes sense in any market environment. But before you boost your bond exposure beyond its normal levels, make sure you understand exactly how much money you could lose if you make the wrong call.

Stocks may be attractive values right now, but you have to stay away from obvious losers. Fool Jordan DiPietro unearths several trash stocks that only Oscar the Grouch could love.

Fool contributor Dan Caplinger is appalled at what passes for interest rates these days. He owns shares of iShares Barclays TIPS Bond. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy's word is its bond.


Read/Post Comments (4) | Recommend This Article (5)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On September 01, 2010, at 9:40 PM, ETFInvestor wrote:

    Dan,

    Great article and very helpful. When you evaluate bond ETFs, which yield numbers do you typically use? For example, http://us.ishares.com/product_info/fund/overview/AGG.htm

    It seems like you could use Average Yield to Maturity to get a better sense of what you're buying.

  • Report this Comment On September 29, 2010, at 4:33 PM, DStirfryking wrote:

    Clearly, rates must move up at some point, but as history has shown, it could take MUCH longer than most expect. Realistically, until the macro outlook improves and the Fed stops intervening in the bond market, rates may stay depressed - or dare I say move even lower. Also, yields should be taken in perspective. The spread between Fed Funds rate and the 30yr Treasury has historically been around 200bps - currently it's sitting at 344. Since Bernanke and company plan to keep short term rates low are contemplating additional quantitive easing, narrowing of spreads seem likley to come from the long end. Based on your duration measures, a 100bps decrease would translate into a 30%+ gain for long Treasuries... just food for thought.

  • Report this Comment On September 29, 2010, at 5:25 PM, DStirfryking wrote:

    My mistake, I meant a 200bps decline move would imply 30%+ gain and 100bps would imply 15%+.

  • Report this Comment On December 30, 2010, at 8:17 PM, mathletic wrote:

    Dan, thank you for the analysis. Is it your understanding that the underlying corporate debt held by Jnk is at a fixed rate? If the underlying Corporate paper is at Libor plus Some number of basis points, is duration even an issue?

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