2 things you must know before investing in bond ETFs

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Nov. 27 2019, Updated 1:20 p.m. ET

Investing in bonds is very different from investing in stocks

When researching high-yield bond ETFs such as the iShares High Yield ETF (HYG), it’s easy to be seduced by the large payouts and invest without understanding the risks. There are two important considerations you need to understand before buying any bond fund. First, bond prices are inversely associated with interest rates. Second, corporate bonds pay a “spread” to treasury yields to compensate for their credit risk.

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Rates have been rising recently, which leads to capital losses for bonds. We can quantify the direct impact on the price of a bond by a metric called “duration.” Looking at the iShares website, HYG has an effective duration of 4.07. This means that if interest rates increase by 1%, the price of the ETF will fall by 4.07%. With interest rates still at historical lows, the possibility of mean-reversion over the next decade is a significant risk to holding bonds.

The spread you receive to Treasuries is your compensation for credit risk

Corporate bonds have credit risk, which means they could default and not pay back your principle. Because of this, they pay a higher yield than Treasuries, which don’t have credit risk. The average yield-to-maturity of the bonds in HYG is 5.14%, and the average maturity is 4.56 years. This means you can subtract the five-year Treasury yield from the yield-to-maturity of HYG to find out its “spread,” which is 3.88%. The spread of risky bonds depends on economic conditions. If the economy falls into a recession, the likelihood of default increases, spreads will widen as investors demand higher compensation for the increased risk, and bond prices will fall. Just like with changes in interest rates, if the spread on bonds increases 1%, the price of HYG will fall by 4.07%.

High yield bonds could be a strong performer over the next year, but you need to understand them before you invest

With the Federal Reserve continuing its accommodative monetary policy, interest rates are low and the economy is growing. A growing economy means the risk of default is lower and high yield spreads could compress, leading to high total returns for bondholders.

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