Bond ETFs and Money-Market Funds: Interest-Rate and Credit Risk
Measure how much a bond ETF or money-market fund can move when interest rates or credit spreads change, and choose a fund that fits your time horizon.
What you will learn
- How a bond ETF differs from a single bond held to maturity.
- How to use duration to estimate the price change of a bond fund when yields move.
- What credit risk and credit spreads are, and how they add to interest-rate risk.
- When a money-market fund is a sensible place for money and what it does not protect against.
Explanation
The basic link between bond prices and yields (when yields rise, prices fall) is covered in the macro course (lesson "Bonds and Yields Simply Explained").
A bond ETF never matures
A bond is a loan to a government or company. It pays a fixed interest amount, the coupon, and repays the face value at the maturity date. Holding a single high-quality bond to maturity, you know your euro result in advance if the issuer pays. A bond ETF (exchange-traded fund that holds bonds) is different: it keeps a constant maturity range, for example "1–3 years". It keeps replacing bonds, so it never reaches a fixed end date, and its price can be below your purchase price on the day you need the money.
Yield to maturity and duration
The yield to maturity (YTM) is the annual return you would earn if you bought the bonds today at their market price, held them to maturity and every payment arrived as promised.
Duration (more precisely, modified duration) measures how sensitive a price is to a change in yield. The rule of thumb is:
Price change in % ≈ − duration × change in yield in percentage points
A percentage point (pp) is the simple difference between two percentages: a yield moving from 2% to 3% rose by 1 pp. The formula is an approximation; for large moves the real change differs slightly (convexity).
Rule of thumb, not a guarantee: if you hold a bond fund for about as many years as its duration, a one-off rise in yields is usually offset over time by the higher interest it then earns.
Credit risk and credit spreads
Credit risk is the risk that a borrower pays late, pays less, or does not pay at all (default). Bonds rated BBB− (or Baa3) and above are investment grade; lower ratings are high yield. The credit spread is the extra yield a company bond pays over a comparable government bond. When spreads widen, for example in a recession, company bond prices fall even if government yields stay the same; the duration rule applies here too.
Money-market funds
A money-market fund (MMF) holds very short-term instruments such as bank deposits, short government bills and commercial paper. Its duration is close to zero, so its price moves very little, and its return closely follows short-term interest rates such as the euro short-term rate (€STR), which the European Central Bank (ECB) publishes every business day. An MMF's holdings are a special asset kept separate from the fund company (see lesson 2), but the fund is not a bank deposit and is not covered by deposit protection. Tagesgeld accounts are covered in the course "Personal Finance & Money Management".
| Fund type | Typical duration | Main risk | Fits money needed in |
|---|---|---|---|
| Money-market fund | below 0.5 | falling short-term rates | 0–2 years |
| Short government bonds (1–3 years) | about 2 | small rate risk | 2–4 years |
| Broad euro government bonds | about 6–8 | rate risk | 6+ years |
| Long government bonds (10+ years) | 15 or more | high rate risk | 15+ years |
| Corporate bonds | about 4–6 | rate and credit risk | 5+ years |
Durations are typical; check the factsheet.
Worked example
Hypothetical example: you hold €10,000 in each of four funds. Assumptions: durations of 0.1, 1.9, 15 and 4.5; government yields rise by 1.5 pp in one step; for the corporate fund we look only at a spread widening of 1.0 pp. We ignore interest income during the move, convexity, fund costs, spreads, order costs and taxes.
- Money-market fund: −0.1 × 1.5 = −0.15% → €10,000 × −0.15% = −€15.
- Short government fund: −1.9 × 1.5 = −2.85% → −€285.
- Long government fund: −15 × 1.5 = −22.5% → −€2,250.
- Corporate fund, spread +1.0 pp: −4.5 × 1.0 = −4.5% → −€450.
The same yield change hits the long fund 150 times harder than the money-market fund.
Common mistake
Practice activity
On paper, calculate the approximate euro change for each case:
- €20,000 in a government bond ETF with duration 7. Yields fall by 0.8 pp.
- €8,000 in a corporate bond ETF with duration 6. Government yields stay the same, credit spreads widen by 0.5 pp.
- You need €15,000 for a flat deposit in 18 months. Which fund type from the table fits best, and why?
Show solution
1. −7 × (−0.8) = +5.6% → €20,000 × 5.6% = +€1,120.
2. −6 × 0.5 = −3% → €8,000 × −3% = −€240.
3. A money-market fund (or a protected bank deposit): its duration is far below 1.5 years, so rate rises barely move its price.
Limitations: the duration formula ignores convexity, interest earned during the period and the fact that yields of different maturities rarely move by the same amount.
Key takeaways
- A bond ETF keeps a constant maturity range and has no fixed end date, unlike a single bond held to maturity.
- Price change ≈ − duration × yield change in pp; the same rule works for credit-spread changes.
- Match the fund's duration to your time horizon; short horizons need short duration.
- Money-market funds have very low price risk, but their return follows short-term rates and they are not covered by deposit protection.
Next step
In the next lesson you will see what monthly savings plans and the cost-average effect really do, using exact calculations.
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