Bond ETFs Interest Rate Risk: Why Your “Safe” Fund Drops

“Safe” doesn’t always mean stable.
Did you know that in 2022, some long-term bond ETFs dropped more than 20%—just because interest rates rose? If that sounds like a contradiction, you’re not alone.

When I first bought a bond ETF, I assumed it would just quietly grow like a savings account on steroids. But I quickly learned the hard way: interest rates are the puppet master behind bond performance. Before we dive deeper, if you’re just starting out, check out the best bond ETF brokers for beginners and this guide on what to know before buying a bond ETF—they’ll help you make smarter decisions upfront.

In this article, I’ll break down why bond ETFs fall when interest rates rise, how to spot hidden duration risks, and what you can do to protect your portfolio—no jargon, just clarity.

Table of Contents

What Is Interest Rate Risk in Bond ETFs, Really?

I remember the first time I bought a bond ETF. I thought I was being smart—playing it safe while still earning a little more than a savings account. It was the iShares 7-10 Year Treasury ETF (IEF). Sounded solid, right? U.S. government bonds. What could go wrong?

Well… about six months later, I opened my account and saw it was down 7%. I thought, “Wait, aren’t bonds supposed to not do this?” That’s when I learned the hard way about interest rate risk—and that even so-called “safe” funds can lose money fast if you don’t understand how they work.

💥 So What Is Interest Rate Risk?

Let me explain it how I wish someone had explained it to me:
Interest rate risk is the risk that bond prices will fall when interest rates go up. It’s that simple. Why does this happen? Because new bonds get issued with higher rates, which makes your older, lower-yielding bond less attractive. So if you want to sell it before maturity, you have to offer a discount.

Here’s a simple math analogy:

Let’s say you bought a bond for $1,000 that pays 2% interest, or $20 per year.
A year later, new bonds are paying 4%, or $40 a year.
No one wants your crummy 2% bond anymore unless you drop the price.
To match the new rate, you’d have to sell your bond for about $950, so that $20/year interest equals roughly 4% yield to the buyer.

That drop from $1,000 to $950? That’s interest rate risk in action.

📉 Why This Hits Bond ETFs Harder Than You Think

Now, here’s where most folks get confused: bond ETFs never “mature.” Individual bonds eventually pay you back at par ($1,000), but ETFs are constantly buying and selling a basket of bonds to keep their target maturity range.

That means:

You never “ride it out” to maturity to get full value
You’re always exposed to interest rate risk, especially if you sell when rates are rising
The ETF price reflects market prices of all the bonds it holds, every single day

🧠 Real Example: VGSH vs VGLT

Let me show you what this risk looks like in practice:

Vanguard Short-Term Treasury ETF (V G SH)

Duration: ~2 years
2022 performance: around -4%

Vanguard Long-Term Treasury ETF (VGLT)

Duration: ~17 years
2022 performance: around -29%

The difference is massive, and it’s mostly due to duration—a fancy term that basically measures how sensitive a bond (or bond ETF) is to interest rate changes.

Rule of thumb:
Every 1% increase in interest rates = price drop of about 1% per year of duration.
So a bond ETF with 2-year duration might lose 2% if rates jump 1%, while a 17-year duration fund could drop ~17%.

🚫 Common Misconceptions Retail Investors Fall For

I’ve talked to a lot of folks at work who got burned by the same myths I once believed. Let’s bust a few:

“It’s a Treasury ETF—it can’t lose money!”
→ Wrong. Treasuries are default-safe, but not market-risk-free.
“It pays a steady yield, so I’m fine.”
→ Maybe. But if your ETF loses 15% in a year, that 3% yield doesn’t matter much.
“I’ll just hold it forever and not worry.”
→ Bond ETFs don’t mature. Holding doesn’t guarantee recovery like with individual bonds.

What Is Duration—And Why Should You Care?

When I first started investing in bond ETFs, I kept hearing about this thing called “duration.” At first, I thought it was just the length of time a bond fund held its bonds. I figured, eh, I’m not holding this forever—what’s the big deal? But I couldn’t have been more wrong. Duration isn’t about time—it’s about risk.

Specifically, how much a bond ETF’s price will move when interest rates change. And let me tell you, once I finally understood how duration worked, a lot of past losses made way more sense.

📉 How Duration Translates to Interest Rate Risk

Here’s the plain English version. Duration measures how sensitive your bond fund is to interest rate changes. It’s expressed in years, but it’s not the same as maturity.

Think of it like this: if your bond ETF has a duration of 5, and interest rates rise by 1%, your ETF could drop about 5%. That’s the kicker. The longer the duration, the harder it gets hit.

And that drop? It’s not just on paper if you sell in a panic—which is what I did once during a Fed rate hike cycle. Never again.

⚖️ Short vs. Long Duration: Real Impact of a 1% Rate Hike

Let’s break it down with a simple example. Imagine two funds: one with a duration of 2 years and another with a duration of 18 years. The Fed hikes interest rates by 1%.

The short-duration fund might lose about 2%
The long-duration fund might tank around 18%

That’s a huge difference. A lot of people think bonds are safe, but it really depends on how long your fund is exposed to rate changes.

📊 Real-World ETF Examples: VGIT vs. VGLT

In 2022, I watched this play out in real time. Here’s how two popular Treasury ETFs performed when the Fed got aggressive:

VGIT – Vanguard Intermediate-Term Treasury ETF

Duration: ~6 years
2022 return: -10%

VGLT – Vanguard Long-Term Treasury ETF

Duration: ~17–18 years
2022 return: -29%

I remember opening the chart and just staring at that VGLT drawdown. It didn’t feel like a “safe bond fund”—it felt more like a tech stock crash. That’s when I really understood the danger of ignoring duration.

🔍 Where to Find Duration on a Fund Factsheet

But here’s the part most people miss: duration isn’t always obvious unless you know where to look. It’s not in the ticker name. It’s not on the ETF homepage. You’ve got to dig into the fund factsheet.

Here’s where to look:

On Vanguard’s site, scroll to “Portfolio Composition”, then look under “Portfolio Characteristics”
On iShares, go to the “Portfolio Data” tab
On Fidelity, look under “Key Statistics” or “Bond Details”

You’ll usually see “effective duration” or “average duration.” That number tells you, in years, how sensitive the fund is to rate swings. And now? I never invest without checking it first.

How to Reduce Interest Rate Risk in Your Portfolio

Back when I first saw my bond ETF drop during a rate hike cycle, I panicked and thought about dumping all my fixed income. But after actually digging into the data (and making a few mistakes along the way), I realized you don’t have to abandon bonds altogether—you just need to tweak your strategy to protect against interest rate risk.

There are smarter ways to structure your portfolio so you’re not constantly getting blindsided every time the Fed sneezes.

📏 Shorten Duration Without Sacrificing Safety

The simplest and most effective strategy? Reduce your average portfolio duration. That just means investing in bonds or bond ETFs with shorter interest rate sensitivity.

Let’s compare:

Shorter-duration bonds or ETFs:

React less dramatically when rates move
Typically mature in 1–3 years
Ideal for periods of rising rates or uncertainty

Longer-duration bonds or ETFs:

Offer higher yields sometimes, but at the cost of massive volatility
Can lose double digits in value when rates rise quickly
Better for rate-cutting environments (not tightening cycles)

🪜 Stagger Your Maturities: The Bond Ladder Trick

If you’re building a personal bond portfolio (not just ETFs), consider using a laddering strategy. It sounds fancy, but it’s simple: buy bonds that mature at regular intervals—like one year, two years, three years, and so on.

What that does:

Gives you predictable cash flow as bonds mature
Allows you to reinvest into higher-yielding bonds if rates rise
Smooths out the impact of timing risk

Even if you stick with ETFs, you can mimic this by mixing different duration ETFs: a bit of VGSH, a slice of VGIT, and maybe a dash of VGLT if you think rates are peaking.

🌊 Floating-Rate Bonds and TIPS: Rate-Proof Tools

Another tool that surprised me? Floating-rate bonds. These are bonds whose interest payments adjust as rates go up.

Pros of floating-rate bond ETFs (like FLOT – iShares Floating Rate Bond ETF):

Low duration (often under 1 year)
Coupon payments increase when the Fed raises rates
Great for inflationary or tightening periods

And then there are TIPS—Treasury Inflation-Protected Securities. While not a pure interest rate hedge, they’re indexed to inflation, so they protect purchasing power.

💰 When to Favor Money Market Funds Over Bond ETFs

There are times when, honestly, you’re better off just parking cash in a money market fund instead of reaching for a bond ETF. In 2022, when rate volatility was extreme and bond ETFs were losing value left and right, my best-performing holding was a boring old money market fund.

Here’s why money market funds (like VMFXX – Vanguard Federal Money Market Fund) might be the better bet:

Yield adjusts quickly as Fed funds rate rises
Virtually no price volatility (NAV stays stable)
Daily liquidity, no lock-ups

Bottom Line

Over the years, I’ve learned that blindly chasing yield is a dangerous game—especially in a rising rate environment. These days, I stay nimble. When the Fed gets aggressive, I favor short-duration and floating-rate bonds to reduce volatility. TIPS help protect my purchasing power when inflation sticks around longer than expected. And when rate hikes slow down? That’s when I cautiously rotate back into intermediate or long-term bonds.

The truth is, interest rate risk doesn’t mean you have to avoid bonds altogether. It just means you need a plan. By understanding duration, diversifying your bond exposure, and leaning into tools like money market funds when needed, you can protect your portfolio from unnecessary drawdowns. Balance, not bravado, is how I hedge today.

Bond ETFs Interest Rate Risk: Why Your “Safe” Fund Drops