Bond ETFs

What a bond fund holds 

A bond is a loan written as a tradeable security. The issuer, a government or a company, receives money at issue, pays interest at a stated rate on stated dates, and repays the face amount at maturity. A bond fund holds many of these at once, selected by a rule book that specifies the issuer type, the credit quality and the range of maturities. The fund does not hold them to maturity in the way a single investor might: as bonds age out of the fund's stated maturity range they are sold and replaced, so the portfolio's characteristics stay roughly constant while its individual holdings turn over.

The funds in the catalog span the standard divisions of the market. The iShares 20+ Year Treasury fund holds long dated American government debt only, which makes it the most rate sensitive of the group and the one with no meaningful credit risk. The iShares Core US Aggregate and Vanguard Total Bond funds hold the broad investment grade market, mixing government, agency, mortgage and corporate paper across maturities. The iShares Investment Grade fund holds corporate debt rated investment grade. The iShares High Yield fund holds corporate debt rated below it, where the interest paid is higher because the probability of the issuer failing to pay is higher.

Price and yield move in opposite directions 

A bond's future payments are fixed at issue. Its yield is the return those fixed payments represent at the price a buyer pays today, so the two are two ways of stating the same fact. When prevailing yields on comparable new debt rise, an existing bond paying the older, lower rate is worth less, and its price falls until its yield matches what is available elsewhere. When prevailing yields fall, the same bond is worth more. That inverse relationship is arithmetic rather than sentiment, and it is the single most important thing to hold when reading a bond fund's price.

The consequence for a fund is that its price chart reads as an inverted picture of the yield of the bonds it holds. A period in which a fund's price falls steadily is, in the market's own terms, a period in which yields rose, and the income the portfolio pays out over that period is a separate stream that the price chart does not show.

Duration measures how much 

Duration states how sensitive a bond or a portfolio is to a change in yields, expressed in years. Its useful form is an approximation: for a small change in yield, the percentage change in price is roughly the duration multiplied by the change in yield, with the opposite sign. Longer dated bonds have higher duration because more of their value sits in payments further away, which is why a fund of long dated government bonds moves several times as much as a short dated fund on the same change in yields.

Credit spread is the second driver 

A corporate borrower pays more than a government of the same currency and maturity, and the difference is the credit spread. It compensates the lender for the possibility of default and for the lower liquidity of corporate paper. A corporate bond fund therefore responds to two things at once: the government yield underneath it and the spread on top. Those two can move in opposite directions, which is why an investment grade or high yield fund sometimes rises on a day when government yields rise, or falls on a day when they fall.

The lower the credit quality, the more the fund behaves like an equity holding and the less like a rate instrument. High yield debt is the clearest case: its spread widens when the economic outlook deteriorates, at the same time as equities fall, and it narrows in periods of confidence. That is the basis for the convention of reading high yield spreads as a risk appetite indicator rather than purely as a bond market signal.

The fund trades more than the bonds inside it 

Bonds do not trade on an exchange. They change hands over the counter, in negotiated sizes between dealers and institutions, and a given corporate bond may not trade at all on a given day. A bond fund puts a continuously quoted, exchange listed price on top of that market, and the fund's own shares frequently trade far more often than its holdings do. The mismatch is a genuine structural feature rather than a defect, and it has two visible effects.

First, the fund's price is often the more current of the two numbers. Net asset value is struck using dealer marks and pricing models for bonds that have not traded, so in a fast moving session the exchange price of the fund can lead the published value of the portfolio rather than deviate from it. Second, the premium and discount that results is wider and more persistent than it is for a fund holding liquid shares, particularly in stressed conditions when dealers widen their own quotes. Creation and redemption for bond funds is also more often done in cash than in kind, which changes the cost of closing that gap.

What moves them, and when 

Bond funds respond to the calendar of macroeconomic releases more directly than most equity funds. Central bank rate decisions and the guidance published with them set the front end of the yield curve. Inflation prints move expectations of where policy will go. Labour market data does the same. Government issuance calendars and auction results affect supply. Credit conditions, default rates and rating actions move spreads. For funds holding foreign debt, the currency of the holdings adds a separate component to the return.

The funds themselves trade in the session of the exchange that lists them, which for those named here is the American equity day. The underlying government bond market trades for longer, so a fund's opening price on a morning after a large overnight move in yields commonly opens away from its previous close rather than travelling there during the session. Most bond funds distribute income monthly, and the fund's price steps down on the distribution date by roughly the amount distributed.