How does the market correct the price of government bonds ETF's? Does it?

Question

A year ago I started to put some of my savings in investments, and to start safely, I bought eurozone government bonds ETF's. One year later, these are down 17%.

At first I was astonished how that could happen: the underlying bonds will give you a certain amount of money after a certain date, not more than that, and if many people are willing to pay more for the underlying bond than that amount, e.g. if you think it's safer or cheaper than keeping it on the bank or under your mattress, it won't be by much. The risk of a country defaulting seems low, several of them at once even lower. In any case, if you really want, I guess you can find out the approximate value (to you, of the underlying assets) quite easily, and naively it seemed very unlikely that the market would greatly over- or underestimate this value.

On the other hand, if there are enough naive people like me that just assume this to be the case, everything can happen: we just buy it at the market price without analyzing the value ourselves. Even an informed trader could buy it at a price higher than reasonable for the underlying bonds, under the assumption that he can later sell it at a profit to someone like me, if there are enough of us .

Can it generally be assumed that the market value would be strongly correlated to an underlying value (which in this case should have been quite easy to estimate, no visionary powers needed)? How would the market correct for it? Was there a bubble due to the ETF obfuscating the underlying assets? Is there some fundamental misunderstanding on my side?

Answer 1

Government bond prices are negatively correlated to underyling interest rates. As interest rates go up (which they have), the price of existing bonds goes down, as consumers can now buy bonds issued at higher coupon rates.

Say you buy a government bond that pays 2%, and over time rates rise to 4%. Why would I pay the same for a government bond paying 2% as one paying 4%? Obviously you'd pay less for one that pays less interest, so the price of the existing bond goes down. The longer the term of the bond, the more sensitive it is to changes in interest rates. So a relatively small change in interest rates can have a larger effect on the value of the bond.

There's no conspiracy, fraud, or foolishness involved here. It's just the dynamics of the market.

Now, your investment is safe - in most cases (and especially the eurozone), there's virtually zero risk of the government defaulting. You're guaranteed to get the coupon rate of the bond for the life of the bond. But, if interest rates rise, that investment now has an opportunity cost because you could be getting higher coupons with current bonds. So there is an unrealized loss that you would only incur should you decide to sell your bonds and buy something else. Over time, the value of your bond would move closer to the par amount the closer you get to the bond's maturity.

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EDIT:

I just realized that you're invested in an ETF and not a single bond. The principles above about individual bond values still hold, but since an ETF contains MANY bonds, and buys and sells them regularly, it's value won't necessarily go up just because time passes like an individual bond would. If it sells bonds to rebalance its portfolio, it would realize losses for those sales. But presumably they're buying at higher interest rates, so over time that higher interest would increase the ETF value (so long as interest rates don't drop more).