The Seesaw Between Interest Rates and Bond Prices

Bond ETF prices move in the opposite direction to interest rates. When rates rise, the bonds a fund holds become less valuable, so the ETF’s price falls; when rates fall, its price rises. How much it moves depends mainly on the fund’s duration: a bond ETF with a duration of six years would be expected to fall about 6% if rates rose by one percentage point.

Short-term bond ETFs barely move when rates change, while long-term bond ETFs can swing as sharply as stocks. The good news is that rising rates also lift the income a bond fund pays, so investors who hold on long enough can recover the price fall through higher yields over time.

The market doesn’t care whether you understand the risks. It will expose you to them regardless. FRC’s three ETF programmes, ETF Investing for Beginners, ETF Investing Strategies and Advanced ETF Investing, explain how bond funds really behave, so a move in interest rates never catches you off guard. They are written in plain English, need no finance degree, and are open to everyone.

This guide is part of FRC’s complete step-by-step guide to investing in ETFs. It explains why bond ETF prices react to interest rates, how to measure that sensitivity and how to choose bond funds that suit your plans.

Why Bond Prices Fall When Rates Rise

A bond pays a fixed rate of interest. If you hold a bond paying 3% and new bonds start paying 5%, nobody will pay full price for yours, because they can buy the new ones instead. Your bond’s price has to fall until its yield is competitive with the new bonds.

The reverse is also true. If rates fall to 2%, a bond paying 3% becomes more attractive, and its price rises. FRC’s guide on why bond prices fall when interest rates rise explains this relationship in more detail.

A bond ETF is simply a basket of bonds. When rates move, the prices of all the bonds it holds adjust, and so does the value of the fund. Because the ETF trades on an exchange all day, you see that adjustment in its share price immediately.

Before you invest your first dollar, make sure you understand the investment. ETF Investing for Beginners explains how bond funds work, what drives their prices and where they fit in a portfolio.

Duration: The Number That Tells You How Much It Will Move

Duration measures how sensitive a bond or bond fund is to changes in interest rates. It is expressed in years, but the most practical way to use it is as a rule of thumb: for every one percentage point change in rates, also called 100 basis points, a fund’s price moves by roughly its duration in percent, in the opposite direction.

A bond ETF with a duration of two years would be expected to fall about 2% if rates rose by one percentage point, and rise about 2% if they fell by the same amount. A fund with a duration of six years would move about 6%, and a fund with a duration of 17 years about 17%.

Every bond ETF publishes its duration, usually as effective duration, on its fact sheet and website. It is one of the most important numbers to check before buying. FRC’s guide to Macaulay duration vs modified duration explains the different ways duration is measured.

A Worked Example

Take $10,000 invested in a bond ETF with a duration of six years and a yield of 4%. If interest rates rise by one percentage point, the rule of thumb suggests the fund’s value falls by about 6%, to around $9,400.

The fund’s yield then gradually rises towards 5% as it replaces older bonds with new, higher-paying ones. In the first year after the rise, the income on your investment might be close to $470 rather than the $400 you were receiving before.

Year by year, that extra income chips away at the price fall. If rates stay at their new level, the investor who holds on for around six years can expect to end up roughly where they would have been had rates never moved, and better off afterwards.

The same $10,000 in a long-term fund with a duration of 17 years would have fallen by around $1,700 from the same one-point rise. The income boost is larger, but the recovery takes far longer.

What Determines a Bond ETF’s Duration?

The biggest factor is how long the fund’s bonds have until they mature. Bonds that will be repaid soon have little time for rate changes to matter, so short-term funds have low duration. Bonds that mature in 20 or 30 years lock in their interest rate for decades, so their prices react much more.

The size of the bonds’ interest payments matters too. Bonds that pay higher coupons return more of their value earlier, which slightly lowers duration. Zero-coupon bonds, which pay everything at maturity, have the highest duration for their maturity.

Duration is not the same as maturity. Because a bond pays interest along the way, its duration is shorter than its time to maturity, except for zero-coupon bonds. A 25-year Treasury bond, for example, typically has a duration closer to 17 years, which is still enough to make its price highly sensitive to rate changes.

Some bonds change their behaviour as rates move. Mortgage-backed securities and callable bonds can be repaid early when rates fall, which limits how much they gain. That is why fund providers report effective duration, which accounts for these features.

Why Duration Is Only an Estimate

Duration gives a good estimate for small rate changes, but it is not exact. The relationship between bond prices and rates is curved rather than a straight line, a feature called convexity.

For most ordinary bonds, convexity works slightly in your favour: prices rise a little more when rates fall than they drop when rates rise by the same amount. For large rate moves, the real price change can differ noticeably from the simple duration estimate, so treat it as a guide rather than a guarantee.

How Different Bond ETFs React

Short-term bond ETFs, holding bonds that mature within about one to three years, typically have durations of around two years or less. Their prices move only a little when rates change, which makes them a common choice for money needed in the next few years.

Intermediate bond ETFs, including broad funds tracking the whole US investment-grade bond market, typically have durations of around five to seven years. They offer more income than short-term funds but react more to rate changes.

Long-term bond ETFs, especially those holding Treasury bonds maturing in 20 years or more, can have durations of 15 years or more. They can rise sharply when rates fall, but they can also fall as much as stock funds when rates rise.

Long-term funds usually pay higher yields than short-term funds in normal conditions. That extra yield, sometimes called the term premium, is the compensation investors demand for tying up money for longer and accepting more price swings.

Floating-rate bond ETFs hold bonds whose interest payments reset with market rates. Their durations are close to zero, so their prices barely react to rate changes, although they still carry credit risk.

Understand the risks, costs and mechanics before making your investment decisions. ETF Investing Strategies shows you how to match bond fund duration to your time horizon and goals.

What 2022 Taught Bond ETF Investors

In 2022, the US Federal Reserve raised interest rates rapidly to fight inflation, and bond markets suffered one of their worst years on record. The broad US investment-grade bond market fell about 13% that year, its worst calendar year in decades.

Long-term Treasury bond ETFs fell far more, with some losing around 30% in a single year. Many investors who had bought them as a safe haven were shocked to see losses as deep as those in the stock market.

The lesson was not that bonds are dangerous, but that duration matters. Short-term bond funds fell only modestly in 2022, while long-term funds suffered stock-like losses. The investors hit hardest were often those who had not realised how much interest rate risk they were taking.

The Silver Lining: Higher Rates Mean Higher Income

When rates rise, a bond ETF’s price falls, but its income starts to rise. As older bonds mature or are sold, the fund replaces them with new bonds paying higher interest, so its yield gradually increases.

That higher income can make up for the earlier price fall over time. A useful rule of thumb is that it takes roughly as many years as the fund’s duration to recover a price fall caused by rising rates, if rates then stay at their new level. For a fund with a duration of six years, that means around six years.

This is why investors who need their money in a few years usually choose short-duration funds, while investors with long time horizons can tolerate more duration in exchange for higher income.

When Bond ETF Prices Drift From Their Value

In calm markets, a bond ETF’s price stays very close to the value of its bonds. In stressed markets, the bonds themselves can become hard to trade, and the ETF can trade at a noticeable discount to its net asset value.

That happened in March 2020, when many bond ETFs briefly traded several percent below the value of their holdings as investors rushed for cash. The gaps closed once markets settled, but investors who sold at the worst moment locked in losses. FRC’s guide on what happens to your ETF during a stock market crash explains why.

Bond ETFs vs Individual Bonds

An individual bond has a fixed maturity date. If you hold it to maturity and the issuer does not default, you get your full face value back regardless of what rates have done in the meantime.

Most bond ETFs work differently. They never mature, because they keep selling bonds as they approach maturity and buying new ones to keep their duration roughly constant. That means there is no fixed date when you are guaranteed to get back what you paid, and your result depends on the price when you sell.

Target-maturity or defined-maturity ETFs offer a middle ground. They hold bonds that all mature in a particular year, then close and return the proceeds, behaving more like an individual bond while keeping the diversification of a fund. As their maturity date approaches, their duration shrinks, so their prices become less and less sensitive to rate changes.

Credit Risk and Other Influences on Bond ETF Prices

Interest rates are not the only thing that moves bond ETF prices. Corporate and high-yield bond funds also react to credit risk, the danger that issuers will fail to pay. When the economy weakens, the extra yield investors demand for that risk can rise, pushing prices down even if Treasury yields fall.

That is why high-yield bond ETFs often behave more like stocks in a downturn, while high-quality government bond funds often rise. FRC’s guide to investment-grade vs high-yield bonds explains the difference.

Inflation matters too. Rising inflation tends to push interest rates up, which hurts bond prices. Treasury Inflation-Protected Securities adjust their principal for inflation, so TIPS ETFs can offer some protection, although they still fall when real interest rates rise.

The Yield Curve: Short and Long Rates Move Differently

The Federal Reserve sets short-term interest rates directly, but long-term rates are set by the market, based on expectations for growth, inflation and future Fed policy. The two do not always move together.

History shows how loosely the two can be linked. Between 2004 and 2006, the Federal Reserve raised its short-term rate by more than four percentage points, yet long-term Treasury yields rose far less, and long-term bond funds held up far better than many investors expected. A Fed rate rise does not automatically mean the same rise in long-term yields.

If short-term rates fall but long-term rates stay the same, short-term bond funds benefit most. If long-term rates rise because investors expect higher inflation, long-term funds suffer most even if the Fed has not acted. FRC’s guide to the normal vs inverted yield curve explains how the shape of the curve affects bonds of different maturities.

How to Manage Interest Rate Risk With Bond ETFs

Match duration to your time horizon. A common rule of thumb is not to hold a bond fund whose duration is longer than the time until you need the money. Money you need within a few years generally belongs in short-duration funds, while money you will not touch for a decade or more can carry more duration.

Diversify across maturities. Combining short, intermediate and long-term funds, or using a broad bond market ETF, spreads your exposure across the yield curve. Some investors build a ladder of target-maturity ETFs, with funds maturing in different years.

Keep cash needs in cash. Money for emergencies or bills in the next year or so is usually better held in a savings account, money market fund or ultra-short bond fund, where the price barely moves at all.

Remember why you hold bonds. For many investors, bonds are there to steady a portfolio and provide income, not to bet on interest rates. FRC’s guide to the three-fund portfolio shows how a bond fund fits alongside stock funds.

In a taxable account, remember that bond ETF income is usually taxed as ordinary income. FRC’s guide to how ETFs are taxed in the United States explains the rules for Treasury, municipal and corporate bond funds.

The Pros and Cons of Bond ETFs

Bond ETFs make it easy to own hundreds of bonds in a single trade, at low cost, with the ability to buy or sell at any time during the trading day. They pay regular income, usually monthly, and provide a cushion against stock market falls in many, though not all, market conditions.

The drawbacks are real too. Most bond ETFs have no maturity date, so there is no guaranteed point at which you get your money back. Their prices fall when rates rise, their income is usually taxed as ordinary income, and in stressed markets they can trade at a discount to the value of their holdings.

Understanding those trade-offs, and choosing the right duration and credit quality for your needs, is what separates a bond fund that steadies your portfolio from one that surprises you.

Don’t let a lack of investment knowledge become the most expensive mistake you ever make. Advanced ETF Investing goes deeper into duration, yield curves and building a fixed-income portfolio that can handle any rate environment.

Common Questions

What happens to bond ETFs when interest rates rise? Their prices usually fall, because the bonds they hold become less valuable compared with new bonds paying higher rates. The size of the fall depends on the fund’s duration, and the fund’s income tends to rise over time.

What happens to bond ETFs when interest rates fall? Their prices usually rise, because the bonds they hold pay more than newly issued bonds. Long-duration funds gain the most.

What is duration in a bond ETF? Duration measures how sensitive a bond fund is to interest rate changes. As a rule of thumb, a fund’s price moves about 1% in the opposite direction for each year of duration when rates change by one percentage point.

Which bond ETFs are least affected by interest rates? Short-term bond ETFs and floating-rate bond ETFs have the lowest duration, so their prices move the least when rates change.

Can you lose money in a bond ETF? Yes. Bond ETF prices fall when interest rates rise or when credit conditions worsen, and unlike an individual bond held to maturity, most bond ETFs have no maturity date that guarantees your money back.

Are bond ETFs a good investment when interest rates are high? Higher rates mean bond funds pay more income, and if rates later fall, their prices can rise too. That does not guarantee gains, because rates can keep rising, but starting yields have historically been a reasonable guide to a bond fund’s long-term return.

Do interest rate cuts help bond ETFs? Usually, yes. When the Federal Reserve cuts rates, short-term yields tend to fall, which lifts bond prices. Long-term funds gain most if long-term rates also fall, although they do not always move in line with the Fed.

Why are long-term bonds more sensitive to interest rates? Because their fixed interest payments are locked in for longer. If rates rise, a long-term bond is stuck paying below-market interest for many years, so its price has to fall further to compensate a buyer.

Why are bond ETFs going down? Usually because interest rates or bond yields have risen, which lowers the value of the bonds the fund holds. Worsening credit conditions can also push corporate and high-yield bond funds down.

Is it a good time to buy bond ETFs? Nobody can reliably predict interest rates. Rather than timing the market, many investors choose bond funds whose duration matches when they will need the money, and buy them as part of a long-term plan.

Should I sell my bond ETFs when rates are rising? Not necessarily. Rising rates mean higher income over time, and selling locks in the price fall. Many investors hold bond funds whose duration matches their time horizon and let higher yields work in their favour.

Your Portfolio Deserves an Educated Investor

Bonds have a reputation as the safe part of a portfolio, and for many investors they are. But a bond fund’s safety depends on what it holds, how long its bonds have to run and how rates move.

Your hard-earned money represents years of work. Give it the respect it deserves. FRC’s three progressive ETF programmes take you from how bond funds work, through matching them to your goals, to managing a portfolio that can handle rising and falling rates. FRC’s programmes and memberships are open to everyone, whether you are investing $500 or $500,000.

Invest in understanding the market before investing in the market itself. Know your duration before the next rate move tests it.