In July, fixed-income ETFs inflows hit a record $39 billion, reflecting a growing bet on the Federal Reserve beginning a rate-cutting cycle. As economic indicators soften, bond funds of all types have seen significant inflows, from long-term government bonds to short-term corporate and municipal ETFs.

The surge follows a U.S. Treasury rally that pushed yields to their lowest levels in months, with traders now anticipating a 100% chance of a September rate cut.¹ With the latest U.S. Consumer Price Index data showing that inflation cooled to 2.9% in July, the Fed might have all the economic data that they need to finally cut rates, driving further interest in bonds.²

Given this potential for rate cuts, investors are increasingly looking towards long-duration U.S. Treasuries, known for their heightened sensitivity to interest rate changes. For those attuned to market dynamics, there is a compelling opportunity in these kinds of bonds. Understanding the intricacies of bond duration and its implications is key to capitalizing on this potential upside.

So, let’s examine duration in fixed-income investing, how it relates to the relationship between interest rates and bond prices, and why, in the face of falling interest rates, investing in long-duration U.S. Treasuries could make sense for your portfolio.

Understanding Duration in Fixed Income

Duration is a key factor in fixed-income investing, so how should we best understand it?

Duration measures a bond’s sensitivity to interest rate changes, factoring in maturity, yield, and coupons. The duration is effectively an estimation of how much the price of a bond will fluctuate with shifts in interest rates.

Longer-duration bonds, such as 20-year Treasury, are more sensitive to rate changes, seeing greater value fluctuations in changing rate environments. The value of longer-duration bonds can decrease sharply when rates rise. However, when interest rates fall, the value of these bonds tends to increase significantly, making them attractive for investors expecting rate cuts, as there exists the potential for capital appreciation.³

The Inverse Relationship: Interest Rates and Bond Prices

Related to duration is the importance of the inverse relationship between bond prices and interest rates and how that helps determine bond yields.⁴

Simply put, as rates fall, bond prices rise. Conversely, when interest rates rise, bond prices fall. This inverse relationship results from bonds having a fixed interest rate (their coupon rate) based on their time of purchase, which represents the annual income an investor can expect from a particular bond. This coupon rate means secondary markets must adjust pricing based on the prevailing interest rates when existing bonds are bought or sold. Lower interest rates make newly issued bonds less enticing, prompting a price increase for existing bonds with higher rates to attract investors.⁵

This relationship between interest rates and bond prices is more pronounced in longer-duration bonds due to their extended time horizons, which magnify the impact of rate changes on the value of the bond. For example, a one-year duration bond would gain just 1% in value if rates fell by 1%, but a 10-year Treasury bond would gain 10% given that same 1% drop in interest rates.⁶

With multiple rate cuts on the horizon, long-duration bonds offer investors a unique opportunity to capture significant price appreciation. Given the current economic environment and expectations for the Fed’s actions, allocating a portion of your portfolio to long-duration Treasuries, such as in a fixed-income ETF that gives exposure to these assets, could be a prudent strategy to enhance returns while managing risk.

The potential for capital appreciation, driven by expected rate cuts, positions long-duration bonds as a valuable component of a diversified portfolio. By understanding the dynamics of duration and market trends, investors can make informed decisions that align with their financial goals.

ETF Options for Bonds

If you’re looking for an opportunity to diversify your portfolio with fixed-income holdings like bonds, one option is investing in fixed-income ETFs.

The Evolve Enhanced Yield Bond Fund (BOND ETF) offers investors an affordable opportunity to invest in long-duration U.S. Treasuries. BOND seeks to deliver attractive monthly income and long-term capital appreciation. To enhance yield, as well as mitigate risk and reduce volatility, BOND will employ an active covered call option writing program on 50% of the portfolio.

For more information on BOND, explore fund details here.

For more blogs like this, and for insight on investing and investment products, sign up for our weekly newsletter here.

 

Sources

1. Hajric, V., “Bond ETFs Amass Record $39 Billion in July in Big Rate-Cut Bet,” Bloomberg, August 1, 2024; https://www.bloomberg.com/news/articles/2024-08-01/bond-etfs-amass-record-39-billion-in-july-in-big-rate-cut-bet
2. Smialek, J., “Inflation Cools to 2.9%, Shoring Up Case for a Fed Rate Cut,” The New York Times, August 14, 2024; https://www.nytimes.com/2024/08/14/business/cpi-inflation-july.html
3. “Understanding Duration,” PIMCO, n.d.; https://www.pimco.com/us/en/resources/education/understanding-duration
4. Lioudis, N., “Inverse Relation Between Interest Rates and Bond Prices,” Investopedia, June 29, 2024; https://www.investopedia.com/ask/answers/why-interest-rates-have-inverse-relationship-bond-prices/
5. “How Bond Prices Affect Yields: A Comprehensive Guide,” Aspero, February 23, 2024; https://www.aspero.in/blog/relationship-between-bond-price-and-bond-yield/
6. “Understanding Duration,” PIMCO, n.d.; https://www.pimco.com/us/en/resources/education/understanding-duration

Source: Getty Images Credit: Casper1774Studio

The contents of this blog are not to be used or construed as investment advice or as an endorsement or recommendation of any entity or security discussed. These contents are not an offer or solicitation of an offer or a recommendation to buy or sell any securities or financial instrument, nor shall it be deemed to provide investment, tax or accounting advice. The information contained herein is intended for informational purposes only.

Commissions, management fees and expenses all may be associated with exchange traded funds (ETFs). Please read the prospectus before investing. The indicated rates of return are the historical annual compound total returns net of fees (except for figures of one year or less, which are simple total returns) including changes in unit value and reinvestment of all distributions and do not take into account sales, redemption, distribution or optional charges or income taxes payable by any securityholder that would have reduced returns. ETFs are not guaranteed, their values change frequently and past performance may not be repeated..

Certain statements contained in this blog may constitute forward-looking information within the meaning of Canadian securities laws. Forward-looking information may relate to a future outlook and anticipated distributions, events or results and may include statements regarding future financial performance. In some cases, forward-looking information can be identified by terms such as “may”, “will”, “should”, “expect”, “anticipate”, “believe”, “intend” or other similar expressions concerning matters that are not historical facts. Actual results may vary from such forward-looking information. Evolve Funds undertakes no obligation to update publicly or otherwise revise any forward-looking statement whether as a result of new information, future events or other such factors which affect this information, except as required by law.