Some people never learn. Officially, the U.S. economy has been out of recession for two years now. Have you noticed any "boom?" Probably not, unless you happen to work in lower Manhattan or Washington D.C.

Yet the markets are still cycling through waves of optimism. The same pattern repeats itself every few months. Some encouraging data, a few good earnings reports, a bailout here or there, and presto: Boom times are back! Buy now before it's too late! Then the good news fades. The same analysts suddenly lose confidence.

Amidst all this, it's hard to blame anyone who says "phooey" on stocks and parks their money in bonds instead. Your return may be minimal, but at least you're safe, right?

Not necessarily.

Bonds and bond ETFs can be risky, too. The good news is that we have ways to measure various types of bond risk. One of course is credit risk — the quality of the issuer. You want to be sure that interest payments will show up on time and your principal returned.

However, I'm not addressing that type of risk today. Instead, I want to focus on interest rate sensitivity risk. You've probably seen words like "maturity" and "duration." Today I'll tell you what these mean and why knowing them is critical if you invest in bond-related ETFs.

Understanding Bond Risk without the Greek

Good news! You don't need to worry about this.

Open any finance textbook and look up "bond risk." The professors who write these books seem unable to explain it in plain English. And what you see will probably look like gibberish, unless you made an "A+" in advanced algebra.

It's true the calculations are complicated, but as an investor you don't really need to worry about that part. You're concerned about what the numbers mean. Should your maturity be high or low? Is a duration of 5.9 risky, or not?

To answer these questions you first need to understand a basic principle: Risk increases along with time. The probability of any event occurring, whether good or bad, will grow the longer you wait.

For instance, what is the chance you'll be struck by lightning in the next five minutes? The odds are very low — but still more than zero.

Your chance of being hit by bad luck increases over time.

Now, what is the chance you will be struck by lightning at some point in the next five years? Again, it's very low in absolute terms, but much higher than yourfive-minute risk.

And the same is true for bonds ...

Longer Maturity = Higher Risk

In financial terminology, "maturity" is the amount of time it will take for your bond investment to be completely repaid, with interest. A three-month Treasury bill has a maturity of 0.25 years. A ten-year Treasury bond's maturity is 10 years.

As time passes, maturity gets smaller: A year after it's issued, your ten-year bond will have a maturity of nine years. A year later it will be eight years.

In a bond portfolio — which is what you get in a bond ETF — there may be dozens, hundreds, or thousands of different bond issues. So you measure risk by looking at their average maturity.

Average maturity can be a little misleading, though, since the interest payments aren't necessarily on a fixed schedule, and most funds and ETFs don't hold the bonds to maturity. That's why I find "modified duration" is often a better yardstick for comparing bond ETFs.

"Duration" Is What You Need to Know

Duration is a statistic that measures the percentage loss a portfolio should sustain if interest rates rise 1 percent. In other words, duration describes the fund's interest rate sensitivity risk. With rates at historically low levels, this is something all bond ETF investors need to understand.

Let's consider iShares Barclays 7-10 Year Treasury Bond ETF (IEF) as an example. Presently, IEF has a yield of about 3 percent (right in line with ten-year T-bonds). Not bad when you can barely make anything in a bank account.

But how much of your principal is at risk if you buy IEF? Duration gives you the answer ...

According to iShares, IEF has a duration of 7.3 years. This means the principal value of an IEF share should drop 7.3 percent for each percentage point rise in the ten-year yield.

So if the Treasury yield jumps from 3 percent to 4 percent, your IEF shares will drop in value by 7.3 percent. A $1,000 investment will be worth $927, costing nearly two-and-a-half years of dividend payments. Ouch!

Of course, if the yield falls to 3 percent again, then IEF shares will probably come back. Furthermore, the principal value may not matter so much if you're strictly an income investor.

What I find, though, is that most people — especially those who depend on their nest egg to generate current income — have a very hard time sitting through short-term losses. They often get scared and bail out, often at exactly the wrong time.

Duration is a handy tool because it helps you know what to expect. You can then narrow your buying list to ETFs that match your risk tolerance.

Here is a list of ten popular Treasury ETFs and their modified duration as of June 30. I purposely included only U.S. Treasury ETFs so that issuer credit risk is not a variable and you can more readily see the increased risk that comes with longer maturities:

• iShares Barclays Short-Term Treasury (SHV) duration = 0.4 (yield = 0.1 percent)
  
  
• iShares Barclays 1-3 Year Treasury (SHY) duration = 1.8 (yield = 0.9 percent)
  
  
• iShares Barclays 3-7 Year Treasury (IEI) duration = 4.5 (yield = 1.9 percent)
  
  
• iShares Barclays 7-10 Year Treasury (IEF) duration = 7.3 (yield = 2.9 percent)
  
  
• iShares Barclays 10-20 Year Treasury (TLH) duration = 9.7 (yield = 3.4 percent)
  
  
• iShares Barclays 20+ Year Treasury (TLT) duration = 15.2 (yield = 4.2 percent)
  
  
• Vanguard Extended Duration Treasury ETF (EDV) duration = 27.8 (yield = 4.6 percent)

Is the extra yield worth the extra risk?

What does this mean? As you can see in the chart, someone who buys EDV instead of IEF to get an extra 1.7 percent in yield is taking on nearly four times as much interest rate sensitivity risk.

Rates can climb quickly, too ...

For instance from 11/30/2010 to 2/10/2011 (just 50 market days), the yield on 30-year Treasury bonds rose from 4.12 percent to 4.75 percent. EDV fell more than 14 percent during the same period. Think about that before you buy a bond fund just because it has a higher yield.

Of course, rising interest rates aren't the only potential problem when you buy a bond ETF. You have to consider credit risk, yield, and other factors as well. Duration is a tool that helps clarify your thinking. And to make it even better ... it's FREE.

So look for it and use it.

Source: http://www.moneyandmarkets.com

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