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How do they construct etf with say 2-3y duration. I would understand the idea is to create a basket of bonds with such duration and keep it for 2-3y until they all mature to realize the expected book yield. But obviously etf is continuously evolving so they constantly sell and buy bonds to maintain average duration in that range? So say they buy 3 year bond and then 1.5 years later they sell this one and buy a new another 3y bond?

Another question is how do I realize the return or yield. There is a lot of market price fluctuation in etf share affecting returns which is different from buying and holding bonds to realize the yield. How would I earn the yield on this etf as none of the bonds actually deliver face value? When I buy such bond etf all I own is a stock share of that etf and to compute the return I can compare prices today and 3 years from now but in 3 years this etf is just holding a basket of yet another bonds with duration of 3 years.

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  • That's the catch, you never earn the yield because most actually never hold any bonds to maturity. You can look here and the link in that answer for a detailed explanation.
    – AKdemy
    Jul 23, 2023 at 12:23
  • @AKdemy so what is the benefit of these ETF at all? Do I collect the coupons? What do I get if I keep holding the bond ETF shares? I assume they don't go up and down a lot just like bond price would hover around par, unlike stock price that can go up unlimited.
    – Medan
    Aug 11, 2023 at 14:48
  • benefits are mentioned here. 1) If you buy bonds, you will face the same interest income (see the previous paragraph) 2) You need to make only one trade to get a fixed-income portfolio 3) The pay-out is monthly because the ETF holds many bonds at once (related to the last point above) 4) The ETFs maturity is more or less constant making it a great vehicle for duration hedging 5) Bond ETFs are liquid (not so much a benefit with US treasury but very much so with less liquid bond markets)
    – AKdemy
    Aug 13, 2023 at 18:23

1 Answer 1

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So say they buy 3 year bond and then 1.5 years later they sell this one and buy a new another 3y bond

Possibly, or buy slightly longer duration bonds to even out the overall duration, depending on how precisely the fund manages its duration.

Another question is how do I realize the return or yield.

Unlike individual bonds, you aren't guaranteed the yield of an ETF for the reasons you mentioned. Investing in Bond ETFs is more an investment on interest rates (plus credit levels for corporate bond ETFs) than an investment in the bonds themselves.

Your "realization" is the coupons that the bonds pay out plus the gains from buying/selling bonds, in the form of interest and capital gain distributions from the fund. The total return is that plus the increase/decrease in value of existing bonds as interest rates change.

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  • @D Stanley: do the bonds coupon get passed to the owner of the etf share? So in the case of rates going up, the newly issued bonds have higher coupons and as a result the owner of ETF receives higher coupons? And this lasts until the ETF provider holds those bonds which I assume is just a few years. Is it like a dividend paying stock then where the dividend depends on the level of rates? how is it different from dividend paying stock? The latter has more volatile price because it is equity while the former is more stable?
    – Medan
    Aug 11, 2023 at 14:46
  • Yes, interest is distributed (typically monthly), and to some extent, yes, you would get higher interest payouts as bonds are replaces, but if a bond ETF keeps the bonds that are paying a lower coupon, you won't necessarily get the yield that the ETF publishes, because the higher yield is party due to lower bond values. For example, an ETF may hold a bond that pays a 2% coupon but has a 5% yield because the market price has gone down. The ETF would still just pay out the 2% interest, not the 5% yield. The yield would be full realized when the bond matures.
    – D Stanley
    Aug 11, 2023 at 18:25
  • @D Stanley: in your example above I would never get 5% though as this is only if I sell and buy a new one. Basically the yield that is published is the "IF bonds are sold" realized. Assuming the ETF is holding the bond I am only getting 2% on it. Basically it works like a savings account, I get the coupons at the market rate while the balance stays fairly stable(in savings account the balance I earn interest on is fixed)
    – Medan
    Aug 11, 2023 at 18:58

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