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The analysis below assesses the impact of changing interest rates on ETFs SHY, IEF, TLT, MUB, EMB, LQD, JNK and HYG. These ETFs collectively hold $63.2 billion in investor assets, and could experience material price changes in a shifting interest rate environment.

For more than 30 years, interest rates have ground lower and lower, showering exceptional returns on fixed income investors. Rates have finally begun to rise from generational lows, and investors are suddenly beginning to recall that money can in fact be lost in the "safest" of debt securities. This article conducts a basic assessment of the impact on prices of popular bond ETFs in various interest rate shock scenarios.

This is not a prediction of future rate moves, nor is it a recommendation to buy or sell any of the securities mentioned here. Instead, the purpose of the article is to serve as a reminder that modest changes in interest rates will have a material and somewhat predictable impact on bond (and bond fund) prices.

Why Does It Happen

Bonds prices and yields move in opposite directions. Why? Among the most common and popular valuation metrics is to determine the present value of the collective cash flows generated by an asset. Determining the present value means we must discount the value of those future cash receipts, since receiving a dollar in twenty years is less desirable than receiving that same dollar tomorrow. The rate at which we discount those future cash flows determines its present value. Interest rates are the basis for the rate at which we discount cash flows, thus increasing interest rates means increasing discount rates, which in turn means lower present values. Duration provides us a shortcut around performing the meticulous task of making multitudes of calculations. Multiplying the duration of an asset by the negative of the rate shift, we receive an approximation of the change in the current price of an asset. The price/yield relationship is non-linear, and we would need to incorporate its curvature (referred to as convexity) if we were to perform a more precise analysis. For this example, however, we simply perform the quick and easy calculation outlined above, which will bring us relatively close to the true impact of changing rates on bond prices.

What Happens to Widely Held Bond ETFs

The analysis below assesses the impact of changing interest rates on SHY, IEF, TLT, MUB, EMB, LQD, JNK and HYG. These ETFs collectively hold $63.2 billion in investor assets, and span U.S. government bonds, municipal debt, emerging market bonds, and corporate bond funds.

As we can see from the table below, further interest rate increases could be devastating to the value of many widely held investment vehicles. The price changes shown must be taken in context, however. The table displays only the immediate price change resulting from a changing discount rate, displayed in basis points (100 basis points equals one percent). If the rate shift occurs over one year, for example, the total return of the investment must be adjusted upward to reflect any income that has been received. Thus, if the price change in a given scenario is -3%, for example, and the asset has a 3.5% yield, the total return over a one-year period would still be positive. The most notable changes can be seen in the longer duration funds such as TLT, which holds U.S. Treasury bonds maturing in 20 years or more. Since the bonds held in that ETF produce income of less than 3.70% per year (the yield on the 30-year U.S. Treasury bond), there is relatively little cushion if rates were to continue their recent march higher.

Price Changes Resulting From Immediate Parallel Yield Curve Shift

As mentioned in the introduction, this is not a recommendation to sell bonds or bond funds. Rather, this should serve as a reminder to investors that changing interest rates can have a drastic impact on the current price of their holdings. An investor's views on potential future interest rate changes should directly inform their sizing of allocations to assets, which are sensitive to interest rates.

Sources: ishares.com, spdrs.com, etfdb.com

Source: Implication For Key Bond ETFs In A Changing Rate Environment