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I realize this question has been asked a bunch of different ways over the years, but I was hoping to get specific opinions on how a Fed interest rate increases will affect long term bond ETFs (i.e.- TLT or BLV).

This is one of the better / more specific answers that I found on this site. According thereto, a 0.25% Fed increase will decrease long term bond ETFs (of an average holding period of 25 years) by 6.25%, which seems crazy. Having a hard time believing that, I dug a little further and found that in 2005 the Fed rates increased rates about 2% (http://www.newyorkfed.org/markets/statistics/dlyrates/fedrate.html) but yet TLT went up almost 4% that year. A lot to 2005 I am currently overlooking, but TLT didn't drop like a rock as how that theory would have predicted.

It seems like the popular consensus is to stay far away from long term bonds funds when the Fed finally increases interest rates, but if you look at TLT in the mid 2000's (between crashes), it seems like its price wasn't negatively affected by the 4% of Fed interest rate increases during that period.

Granted, one of the cardinal rules of the market is that the past performance does not predict future performance. Today's market differs from the market of the 2000s, but given that long term bond funds did not underperform the last instance of Fed rate increases (and in fact TLT performed much better then short-term bond ETFs that some think you should flock to today), why are people so wary of long-term bond funds before the upcoming Fed interest rate increase?

[Note - please feel free to correct any inaccuracies in any of this]

  • I'm curious to see the answers to this, as I'm not sure I understand Bond ETFs to the degree I understand Stock ETFs. I think there may be a conflation/confusion of NAV versus bid/ask price and/or the actual inherent value of the bonds versus their market value, and from what I've heard Bond ETFs may more commonly have significantly distinct values for those two as opposed to stock ETFs, but I'm very sure I don't understand how bonds work sufficiently to understand how they trade. – Joe Jan 12 '15 at 22:28
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    Note that interest rates depend on duration (the relationship is described by a yield curve.) In the situation you describe, it looks like the rate increase was in the federal funds rate, which is the rate at the short end of the yield curve. By contrast the price of a long-term bond fund like TLT is connected with the rates at the long end of the yield curve. Often the long-term and short-term rates move in tandem, but it is possible for them to move in opposite directions. Perhaps that is what happened in the time frame you described. – Trevor Wilson Jan 17 '15 at 2:04
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To start, long term treasuries have a number of periodic coupon payments before the final principal repayment. So, when you do a weighted average of the time to each payment (one of many similar measures of bond duration) the duration of a 25 year bond is actually closer to 17. So yes long term bonds are very sensitive to interest rate changes which is the simple answer but as you saw in 2005 not the whole story.

Fed interest rates are not completely aligned with bond yields. There are secondary effects like if the fed raises rates and people take it as a reassurance that the market is doing well. In that case people could move money out of treasuries and into more risky instruments lowering the yield and raising prices.

Also, while interest rate changes tend to effect long and short term interest rates similarly over short periods the differences add up over long periods of time like a year. In 2005, the yield for short term treasuries went from 2% at the beginning of the year to about 4% at the end. However, the long term yields started at 4% and remained at 4%. So with no changes all the TLT did for 2005 (approximately) was just collect the 4% interest.

Finally, it is interest rate surprises that matter. For instance, fed hikes are already partially priced into bonds, but in this case the market does not know if the hikes will happen or not. Long bonds are merely more sensitive to this uncertainty (higher duration) so they are hurt more if the hike does happen but gain more if the hike does not happen.

  • To emphasize @rhaskett's point, there is a lot of future expectations already built into the yield curve. The yield curve today already implies a certain trajectory of interest rate similar to chart below: whitehouse.gov/sites/default/files/image/charts/… Only if rates go significantly above these levels would you start to incur losses. – mirage007 Sep 1 '15 at 23:29

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