Why Bond ETFs Fall In Price

Municipal Bond

Dan Bortolotti: When the yield on 10-year federal bonds spiked earlier this year—from 1.88% on May 16 all the way to 2.55% on July 5—the value of broad-based bond ETFs plummeted sharply. But I’ll wager that many investors think their bond ETFs are performing worse than they really are.

There’s a common misunderstanding about how fixed-income ETF returns are calculated. That’s understandable, because your brokerage’s account summary is highly misleading: it indicates only an ETF’s price change while ignoring the all the cash distributions. And lately, 100% of your bond ETF’s return has come from interest payments, not price appreciation. Unless you appreciate that, you might think your ETF has lost money when it’s actually logged a nice gain.

Why bond ETFs fall in price

Most investors understand that bond prices fall when yields rise. What’s less well known is that bond ETF prices will decline steadily even if interest rates don’t change. That’s because virtually all the bonds in a broad-based ETF today were purchased at a premium—in other words, for more than face value. As these bonds mature or get sold, the fund will incur a steady trickle of small capital losses. But that doesn’t necessarily mean your investment will lose money overall, because the interest payments from the bonds will offset at least some those losses.

So far in 2013, broad-based bond funds have indeed suffered negative returns—but the numbers are not as bad as you might think. Here are the year-to-date numbers for three popular bond ETFs (as of July 31). The total return of each fund is significantly better than the price change would suggest, because investors received monthly interest payments along the way:

Price on Price on
Dec 31, 2012 July 31, 2013 Price change Total return
XBB $31.39 $30.31 -3.44% -1.66%
VAB $25.41 $24.48 -3.68% -1.88%
ZAG $15.88 $15.31 -3.59% -2.08%

Now have a look at the year-to-date results for some popular short-term bond ETFs. All of these funds have delivered positive returns this year despite a decline in price:

Price on Price on
Dec 31, 2012 July 31, 2013 Price change Total return
XSB $28.87 $28.57 -1.04% 0.56%
VSB $24.88 $24.66 -0.87% 0.64%
CLF $19.78 $19.47 -1.57% 0.63%
CBO $20.15 $19.84 -1.54% 1.06%

When a loss is really a gain

The numbers are even more dramatic if you go back a few years with the ISHARES 1-5 YR LADDER GOVT BOND FUND(TSE:CLF) and the

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