Long Average Duration Bond Funds and Interest Rate Risk

If you are an investor who thinks bond funds are always a safe investment in which you cannot lose money, guess again. Every investor should understand why the average duration for bond funds is important to interest rate risk. Having a good understanding of the correlation between interest rate and average duration for bond funds means you will make fewer financial mistakes and you will increase your overall net worth. Bond fund values move in the opposite direction of interest rates, so when interest rates go up, your bond fund principal will decrease. Conversely, when interest rates decline, the principal of your bond fund will grow.

Here’s why: for every 1% increase in interest rates the bond fund will go down in value by the average duration of the bond fund (it works the opposite if interest rates go down). For example, if the average duration for the bond fund is 7 years and interest rates go up 2%, the value of your investment will decrease 14% (average duration X interest rate change = gain / loss). Another example, suppose you have $10,000 invested in a bond fund with the average duration of 7 years; if the interest rate goes up 2% you just lost $1400 of your Investment. If the situation is reversed and the interest rate goes down by 2%, you just made $1400.

Here’s a ‘real life’ example of when interest rates go down and bond fund principal increases. Vanguard’s Long Term Treasury Investor Shares (VUSTX) average duration is 13.1 (this is the current average duration of the fund; I do not know the average duration in 2008). On October 31, 2008 the share price was $11.11, on December 18, 2008 the share price was $13.74 this is a gain of 23.7% to the principal. The treasury 20 year bond price deceased by 1.88% (from 4.74% to 2.86%) during the same time period. This is very close to the calculation (1.88 x 13.1) gain of 24.6%. If you had been an investor in long average duration bond funds at the start of the 2008 financial meltdown you would have been a very happy investor indeed. An investor in short average duration bond funds would have had much lower gains. For example, if you invested in a short average duration bond fund with average duration of 3 years, your gain would have been around 5.64%.

The opposite ‘real life’ example occurs when interest rates increase and bond fund principal decreases. Using the same bond fund, Vanguard’s Long Term Treasury Investor Shares (VUSTX) average duration is 13.1. October 1, 2010 the share price was $12.49, on December 31, 2010 the share price was $11.07 this is a loss of 12.8% to your principal. The treasury 20 bond price decreased by .81%. It is reasonably close to the calculation loss of 10.61%. If you ]had been invested in long average duration bond funds during the last quarter with the start of QE2 and all the Bush tax cuts being extended by 2 years you would not have been a happy investor. This is one of the reasons why investors are pulling money out of bond funds. More than $20 billion have been pulled out of bond funds since mid-November 2010, with the weekly outflow in mid-December marking the biggest in more than two years.

The greater the average duration of a bond fund's holdings, the more its share price will fluctuate when interest rates change. This why there is risk in investing in bond funds. Average duration is a very useful measurement of bond fund sensitivity to changes in rates. To make it simple, the greater the average duration of a fund's holdings, the more its share price will fluctuate when interest rates change. To make it even simpler, a rising interest rate climate is not good for bond fund investors. If you think interest rates are going to increase you want to be invested in short average duration bond funds. It is the opposite if you think interest rates are going to increase; in that case you want to be in long average duration bond funds.

Buying individual bonds can take some risk out of investing in bonds. Assuming the issuer is still solvent when the bond matures, you collect the face value of the bond. You will not experience the principal fluctuations to which bond funds are subject.

© 2011 Paul Cusick