Many own bond ETFs because the dividend is higher than for many stocks and it creates an income stream. This can be deceiving. When you buy a Treasury security, the coupon is fixed and if you buy the bond at a price under par ($100) you always know that if you hold it until maturity you will receive your money back.
A bond ETF is based upon a mixture of bonds. The maturities and coupons vary. The managers have to sell bonds and buy new ones to keep the mix equal to a stated maturity range. They may be forced to sell bonds at a loss and buy bonds when they are well over par and ridiculously over-priced. Should they lose too much on these transactions, and of course after taking their management fee, it’s possible you may not even get a dividend and the dividend can vary widely.
Bond prices and their yields have an inverse relationship. Since yields are very low, prices on bonds in these ETFs are very high. That means there is risk to your principal and this is known as convexity risk. An increase in rates on the 30 year bond from a low level of 2.7% to 3.7% could result in a drop of a bond ETF such as the TLT by 16%. Does that sound safe?
Watch this segment of “Options Jive” with Tom Sosnoff and Tony Battista for the valuable takeaways and a better understanding of the convexity risks in the Bond market and the hidden risks in Bond ETFs.
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