When Rates Rise: How A Bond ETF Reacts

| About: iShares 7-10 (IEF)

For the first time in a number of months, long-depressed interest rates have recently started to move up. The 10 year Treasury entered March at 1.97%, having been below 2.10% since last October. During March a combination of positive events, including a broadly more positive outlook on the US economy and a debt exchange in Greece, increased investor optimism which decreased the demand for safe US Treasuries. As a result, the yield on the 10 year Treasury has risen as high as 2.37% in March and settled in Friday at 2.22%. This is a fairly meaningful move over a short period, and it prompted many of our clients to reach out to us with questions about what rising interest rates might mean for their fixed income ETF holdings.

Since fixed income ETFs are relatively new investment vehicles, many of our clients are more familiar with how interest rates affect individual bonds. In fact, the idea of holding an individual bond to maturity is often cited as a hedge against an adverse change in interest rates. If, for example, interest rates increase, an investor can simply hold a bond to maturity and receive the full principal rather than sell the bond at a loss.

But this logic fails to take another kind of loss into consideration - opportunity loss. If you're holding a 10-year 5% coupon bond and rates increase to 6%, you're now forgoing the "opportunity" to receive 1% more per year in yield. You can either choose to incur this loss immediately by selling the bond, or over time by holding the bond to maturity.

By contrast, the majority of fixed income ETFs do not mature, but instead have a "maturity range" that they target - for example, the iShares Barclays 1-3 Year Treasury Bond Fund (NYSE Arca: SHY). As bonds age and fall below the minimum maturity, they are removed from the ETF. The fund then acquires other bonds that fit the maturity profile - at prevailing market yields.

The result: FI ETFs tend to adjust to the current yield environment. Although the net asset value (NAV) of an ETF may increase or decrease due to changes in interest rates, all else being equal there is eventually an offset in the form of falling or rising distributions. The effect is similar to a traditional bond laddering strategy, where an investor purchases securities with differing maturity dates so that when bonds mature, they can use the proceeds to reinvest at current interest rates. The bond ladder is sometimes thought of as not being impacted by rate changes, but the reality is that movements in interest rates will affect the yield and income generated by new bonds that are purchased. An ongoing bond ladder that continuously re-invests into the market ends up looking in many ways like a bond fund or ETF.

Whether you choose an individual bond or a fixed income ETF, your investment will be impacted by rate changes. Understanding that impact is an important step in deciding which vehicle is right for you.

Disclaimer: Investment comparisons are for illustrative purposes only and are not meant to be all-inclusive. . When comparing bonds and iShares Funds, it should be remembered that management fees associated with fund investments, like iShares Funds, are not borne by investors in individual bonds. An investment in the Fund(s) is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency.

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