When the yield on 10-year federal bonds spiked earlier this year—from 1.88% on May 16 all the way to 2.55% on July 5—the value of broad-based bond ETFs plummeted sharply. But I’ll wager that many investors think their bond ETFs are performing worse than they really are.
There’s a common misunderstanding about how fixed-income ETF returns are calculated. That’s understandable, because your brokerage’s account summary is highly misleading: it indicates only an ETF’s price change while ignoring all the cash distributions. And lately, 100% of your bond ETF’s return has come from interest payments, not price appreciation. Unless you understand that, you might think your ETF has lost money when it’s actually logged a nice gain.
Why bond ETFs fall in price
Most investors understand that bond prices fall when yields rise. What’s less well known is that bond ETF prices will decline steadily even if interest rates don’t change. That’s because virtually all the bonds in a broad-based ETF today were purchased at a premium—in other words, for more than face value. As these bonds mature or get sold, the fund will incur a steady trickle of small capital losses.