There's Only 2 Reasons to Buy Vanguard Extended Duration Treasury Index Fund ETF

Income investors often look to bonds and bond exchange-traded funds (ETFs) to generate reliable income streams. That's not a bad choice, but not all bonds are created equal. Just like stocks, you need to understand what you are buying, or you could end up making an investment mistake.

This is why income lovers should tread with caution with the 5% yield currently on offer from Vanguard Extended Duration Treasury Index Fund ETF (NYSEMKT: EDV). It may come with larger risks than you expect.

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Vanguard Extended Duration Treasury Index ETF has an attractive yield

Clearly, the big draw for Vanguard Extended Duration Treasury Index ETF is its yield. For reference, the S&P 500 index (SNPINDEX: ^GSPC) is only offering a skinny 1.1% yield. A short-duration bond offering, such as Vanguard Short Duration Treasury ETF (NASDAQ: VGSH), has a 3.9% yield. By comparison to both, 5% looks highly enticing.

Simply put, if you are trying to maximize the income you generate from your portfolio, you'll likely be attracted to Vanguard Extended Duration Treasury Index ETF. The 1.1 percentage point yield advantage over Vanguard Short Duration Treasury ETF amounts to a 28% increase in the income you will be able to generate. If you are trying to supplement your Social Security check with dividend and interest income from your investment portfolio, that yield lift will be difficult to resist.

And you might be comforted by the fact that the bonds in Vanguard Extended Duration Treasury Index ETF are issued by the U.S. government. It is one of the strongest issuers you can find, given the government's ability to tax residents to raise money. As such, default risk is very low. Some would argue that default isn't even a potential outcome. And yet this ETF is not risk-free.

The intersection of bond prices and interest rates

With a duration of 24 years, Vanguard Extended Duration Treasury Index ETF owns bonds with very long-term maturities. For reference, Vanguard Short Duration Treasury ETF's duration is only 1.9 years. This is a massive difference.

Bond prices adjust when interest rates rise and fall so that the interest rates of existing bonds match the current market rate. The impact of the price changes is exaggerated at the long end of the yield curve, where Vanguard Extended Duration Treasury Index ETF lives. This fact changes the risk equation, and it helps explain why risk-averse investors often prefer short-term bonds.

The big thing that investors need to understand is that the relationship between bond prices and interest rates is an inverse one. Rising interest rates lead to falling bond prices (which increase the bond's interest rate), and falling interest rates lead to rising bond prices (which decrease the bond's interest rate). Which means that investors who expect interest rates to fall will likely find Vanguard Extended Duration Treasury Index ETF appealing from a capital appreciation perspective. That's a second type of investor that might find this ETF attractive.

The problem, of course, is that when rates rise, investors need to be prepared to see the value of Vanguard Extended Duration Treasury Index ETF decline. If you make the wrong call on rates, you could see your investment's value heading the wrong way. And if you buy just for the high yield, you have to be ready for the volatility that comes along with shifting interest rates. You may get the income you want, but rising and falling interest rates could leave you with a case of whiplash from a capital appreciation (and loss) perspective.

Make sure you know what you own with Vanguard Extended Duration Treasury Index ETF

If you are looking to maximize yield, you will probably like Vanguard Extended Duration Treasury Index ETF. But you have to understand the risk/reward trade-off you are making to generate that yield. If you think rates will fall, you'll probably like Vanguard Extended Duration Treasury Index ETF's capital appreciation potential. But you have to go in with the understanding that rates can move in both directions. There's nothing wrong with the ETF, per se, but if you don't go in with your eyes open to the risks of owning long-term bonds, you could end up with unwanted surprises.

Reuben Gregg Brewer has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.