Originally Posted by gindie
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%