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A rise in interest rates causes a rise in bond yields which means their price goes down. And the opposite, of course.

What I'm trying to understand is how the price of an ETF will change after the interest rate hike as time goes by and the bonds in the ETF mature and are replaced.

For example, a ETF composed of 3m to 3y bonds had it's exchange price go down with the recent interest rate hikes. Assuming the interest rate were to remain unchanged going forward, would the ETF's exchange price return to (roughly) it's pre-hike range once 3y have passed and all the bonds in the fund have matured and been replaced by similar ones?

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    Remember that ETFs are continuously buying new bonds as old ones mature, so there isn't a clear point when "all the bonds have matured" and it (ideally) wouldn't matter if there was.
    – keshlam
    Dec 1, 2022 at 19:53
  • But that's what I'm asking. How will the price change as the bonds mature and get replaced with new bonds at the new interest rate? I recognize that it'll be a continuous operation and not a sudden change. Dec 5, 2022 at 16:04

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A bond ETF is nothing but a portfolio of bonds, which all have their own exposure to various points of the yield curve. To anticipate how rate changes impact the ETF, one needs to aggregate the DV01 (dollar value per basis point) by tenor for all bonds in the portfolio. This would need to be recomputed daily as holdings turn over and the exposure changes based on the remaining time to maturity.

It's worth noting that the interest rate curve is constantly moving based on rates expectations not just the actual hikes.

It stands to reason that bond ETFs should gain if the terminal rate is lower than anticipated or if the Fed stops hiking (or even starts cutting) rates sooner than expected, all else equal.

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  • So... assuming a simplistic case where interest rates rise from X% to Y% and then hold there forever with no expectation of it ever changing, will the market price go up, down, or hold steady as the bonds in the fund mature and are replaced at the current, higher rate? Dec 4, 2022 at 19:54
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    Typically, the fund will replace funds in order to maintain the same mixture of maturity times. As such, if bond rates in a steady state, I think its own return should be in a steady state. Assuming the market is being rational, which is a stretch.
    – keshlam
    Dec 5, 2022 at 21:40
  • @BrianWhite let's simplify it further: assume you have one bond. If rates go up, its value immediately drops to reflect the change. When the bond matures, you reinvest the proceeds at the going rate. If rates neither go up nor down, its value won't change (assuming no credit risk or supply/demand drivers). Note that a bond's clean price will converge towards parity at maturity.
    – 0xFEE1DEAD
    Dec 5, 2022 at 22:25
  • Okay, that makes sense. With regard to an ETF then, the shorter the terms of the bonds in that fund, the faster it will return to parity after a rate change. Dec 6, 2022 at 3:42
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    @BrianWhite the term you're looking for is "duration". Long-dated bonds and bonds with no or low coupons have more duration, i.e. are more sensitive to rate changes, than short-dated and high-yield bonds.
    – 0xFEE1DEAD
    Dec 6, 2022 at 4:27

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