Rate Hike In The Cards: How Will Bond ETFs React?

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 – ETF report) 

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 – ETF report)

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.