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I am curious about what determines the value of fixed income ETFs? Is it the prices of bonds? The yields of bonds? Or the coupon of bonds? I know that prices and yields move in inverse directions. So, part of me thinks that as interest rates start to rise, the value of ETFs will start to drop. But, as interest rise, the coupons (i.e. the interest payments they collect) on the bonds held by the ETFs will presumably also rise, so....what is going to dictate the value of an ETF that tracks fixed income securities?

Thank you!

  • Are you assuming fixed coupon bonds, floating coupon bonds, or a mix of both? – D Stanley Aug 22 '17 at 19:16
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    I am not seeing how this relates to your personal finance aside from an academic exercise? Can you elaborate why this is not just homework? – GµårÐïåñ Aug 22 '17 at 20:02
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    It could relate if you have the expectation that interest will rise in the future and want to trade ETFs to capitalize on that assumption. – D Stanley Aug 22 '17 at 20:28
  • Because I am thinking of investing in some fixed income ETFs, but I'm not sure if I should, given that interest rates might rise. – spindoctor Aug 23 '17 at 13:29
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The literal answer to your question 'what determines the price of an ETF' is 'the market'; it is whatever price a buyer is willing to pay and a seller is willing to accept. But if the market price of an ETF share deviates significantly from its NAV, the per-share market value of the securities in its portfolio, then an Authorized Participant can make an arbitrage profit by a transaction (creation or redemption) that pushes the market price toward NAV. Thus as long as the markets are operating and the APs don't vanish in a puff of smoke we can expect price will track NAV.

That reduces your question to: why does NAV = market value of the holdings underlying a bond ETF share decrease when the market interest rate rises?

Let's consider an example. I'll use US Treasuries because they have very active markets, are treated as risk-free (although that can be debated), and excluding special cases like TIPS and strips are almost perfectly fungible. And I use round numbers for convenience.

Let's assume the current market interest rate is 2% and 'Spindoctor 10-year Treasury Fund' opens for business with $100m invested (via APs) in 10-year T-notes with 2% coupon at par and 1m shares issued that are worth $100 each. Now assume the interest rate goes up to 3% (this is an example NOT A PREDICTION); no one wants to pay par for a 2% bond when they can get 3% elsewhere, so its value goes down to about 0.9 of par (not exactly due to the way the arithmetic works but close enough) and Spindoctor shares similarly slide to $90. At this price an investor gets slightly over 2% (coupon*face/basis) plus approximately 1% amortized capital gain (slightly less due to time value) per year so it's competitive with a 3% coupon at par.

As you say new bonds are available that pay 3%. But our fund doesn't hold them; we hold old bonds with a face value of $100m but a market value of only $90m. If we sell those bonds now and buy 3% bonds to (try to) replace them, we only get $90m par value of 3% bonds, so now our fund is paying a competitive 3% but NAV is still only $90.

At the other extreme, say we hold the 2% bonds to maturity, paying out only 2% interest but letting our NAV increase as the remaining term (duration) and thus discount of the bonds decreases -- assuming the market interest rate doesn't change again, which for 10 years is probably unrealistic (ignoring 2009-2016!). At the end of 10 years the 2% bonds are redeemed at par and our NAV is back to $100 -- but from the investor's point of view they've forgone $10 in interest they could have received from an alternative investment over those 10 years, which is effectively an additional investment, so the original share price of $90 was correct.

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