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Monday, May 11, 2015

Another Look at the Total Bond Market Index Fund/ETF... It May Be Riskier Than You Think

I wrote last week that investors have know made the Vanguard Total Bond Index the worlds largest bond fund replacing the actively managed Pimco Total Return Fund.

But an excellent article in the WSJ explains the relationship between duration/maturity and price risk on bonds.

Although duration is not exactly the same as maturity the relationship is the same the longer the maturity of the bond the greater its price sensitivity to changes in interest rates. So nor surprising that in the era of declining...and record low...interest rates long term bonds have had eye popping returns.

As the article notes:
Look at last year’s returns for U.S. Treasurys. Securities maturing in five to 10 years returned 6.4%. Those maturing in 20 years or more returned 27.5%, Barclays index data show. That gap is due to the power of “duration.”

But the power of duration works in both ways at some point (yes the date seems to always get pushed back) the Federal Reserve will start raising rates and the move in bond  prices will be negative

For that reason the Vanguard Total Bond Market Index (ETF BND) may not be the best choice.

 The fund has a current yield of 1.92% and a duration of 5.6 years. That means a 1% increase in interest rates will cause of 5.6% decline in price.

As a point of comparison BSV the Vanguard Short Term Bond ETF has a yield of .97% and at 2.7 years a bit less than half the duration, A 1% increase in interest rates would yield a 2.7% decline in price.

Many people have a short memory but in 2013 the bond markets had a "taper tantrum" a sharp bond market selloff in response to market concerns the Fed was about to raise rates. Not surprisingly longer duration bonds saw the largest losses. In 2013 BSV eeked out a small gain or .17% (total return) while BDN dropped 2.12%.

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