With implied volatility so low, many traders are sitting on their hands waiting for volatility to revert back to its historical average. Meanwhile, many investors are looking toward bonds and bond ETFs for higher yields. But Dr. Data (Michael Rechenthin, PhD) explains how these products may not be as safe as it seems especially if interest rates change.
Tom, Tony and Dr. Data walk us through the current yields of treasuries along with a few bond ETFs. With a visual, Dr. Data explains the current convexity risks associated with holding longer maturity bonds as compared to shorter maturities such as the 2-year note. Since most investors tend not to hold fixed income products for their entire duration, the risk is that interest rates will increase thereby decreasing the price of the investment. As an example he compares the 10-year note to the 2-year note; 10-year notes have 80 basis point better yields, yet are held for 5 times longer than 2-year notes. Additionally, a rise in interest rates will negatively affect the 10-year price far more than the 2-year note.
Bond ETFs are a bit more complex since there are problems associated with looking strictly at their average duration of bonds held. This is because many hold not just treasuries (which have next to no risks of default) but also corporate bonds (which are more prone to economic conditions).
Dr. Data provides a nice visual demonstrating how much three bond ETFs have moved in price when yields have change in notes. He also provides a nice formula to calculate how much these bond ETFs will change depending on your expectation of interest rates.
Watch the segment for more information.
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