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Bond funds and duration
Old 05-04-2011, 07:44 PM   #1
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Bond funds and duration

A question I've never found the exact answer to.

Bond total return is made up of two parts, income return and capital return.

Duration measures the sensitivity of bonds to interest rate movement

Question: If a bond fund's duration is 4 years, does a 1% increase in interest rates drop the total return by 4% or just the capital return?
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Old 05-04-2011, 07:51 PM   #2
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Originally Posted by gindie View Post
A question I've never found the exact answer to.

Bond total return is made up of two parts, income return and capital return.

Duration measures the sensitivity of bonds to interest rate movement

Question: If a bond fund's duration is 4 years, does a 1% increase in interest rates drop the total return by 4% or just the capital return?
It drops the price by approx 4%.

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Old 05-05-2011, 04:13 AM   #3
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You should look at how bonds are valued in the securities market.

If you were going to sell your bond today, how would the bidder value its worth based on a number of factors related to risk.

Plenty of books on the topic... check your local library.
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Old 05-05-2011, 10:11 AM   #4
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Originally Posted by gindie View Post
...

Question: If a bond fund's duration is 4 years, does a 1% increase in interest rates drop the total return by 4% or just the capital return?
It depends what period you are measuring the 1% increase over. If the period of the increase is 1 year then roughly the capital return would decrease by -4% but the interest rate return increase by maybe about 1%. If the rate increase was linear over the period then you'd have about an extra 0.5% over that year from interest increase. So my estimate would be about a -3.5% total return for that year. The next year you'd get the full 1% interest increase. This assumes the fund is keeping it's bond duration constant.

Another way to view this is that on a monthly basis the bond fund gives us:

return = (1 + yield)^(1/12) + duration * (yield at start of month - yield at end of month)

Example of 2.0% yield going up to 2.5% over one month, 4 year duration:

return = (1 + 0.020)^(1/12) + 4 * (0.020 - 0.025) = 1.0017 - .0200 = 0.9817
so expressed in percentages we get:
return in percent = 100*(.9817 - 1.000) = -1.83%
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