[holding high bond allocation when interest rates rise]

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woodedareas
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[holding high bond allocation when interest rates rise]

Post by woodedareas » Sun Aug 26, 2012 11:59 am

Since I am new to this forum . I have a question that arose today with several friends of mine who are about 70 years old. If we have an assest allocations of about 70% in bonds and about 30% in equities and are using the index funds, what adjustment do we make when the economy improves and interest rates escalate. Our 70 % in bonds will take a beating and our limited exposure in equities will not off-set our losses.Our age precludes shifting our allocation. Are there any statistics that justify remaining the course in 70% bonds (Index funds) when the stock market turns the corner and rates increase ?Perhaps my assumption of the beating in the bond index funds during better times is incorrect, but it has always been my understanding that bonds decline as interest rate incline.
I would appreciate your thoughts .

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Re: Change in the Economy

Post by Johm221122 » Sun Aug 26, 2012 12:02 pm

Use CD's,short term bond funds,I bonds,individual bonds or stable value funds
Best wishes
john

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Re: Change in the Economy

Post by Johm221122 » Sun Aug 26, 2012 12:05 pm

Also consider SPIA
http://www.immediateannuities.com/
John

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Re: Change in the Economy

Post by steve_14 » Sun Aug 26, 2012 12:30 pm

Johm221122 wrote:Use CD's,short term bond funds,I bonds,individual bonds or stable value funds
Best wishes
john
+1 exactly what I'd do.

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Re: Change in the Economy

Post by peppers » Sun Aug 26, 2012 1:36 pm

"..the cavalry ain't comin' kid, you're on your own..."

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Re: Change in the Economy

Post by BigFoot48 » Sun Aug 26, 2012 2:14 pm

woodedareas wrote:I would appreciate your thoughts .
I, for one, as a 64 year old with 55% bond funds am looking forward to higher interest rates for the dividends the bonds will throw off, and since I have no plans to sell much or any of the bond funds for a decade or more, don't really care if there's a temporary decrease. But what I really think, since you asked, is that we're in a Japan-style doldrums and interest rates ain't going anywhere for a long, long time.
Retired | Two-time in top-10 in Bogleheads S&P500 contest; 12-time loser

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Re: Change in the Economy

Post by tibbitts » Sun Aug 26, 2012 2:16 pm

woodedareas wrote:Since I am new to this forum . I have a question that arose today with several friends of mine who are about 70 years old. If we have an assest allocations of about 70% in bonds and about 30% in equities and are using the index funds, what adjustment do we make when the economy improves and interest rates escalate. Our 70 % in bonds will take a beating and our limited exposure in equities will not off-set our losses.Our age precludes shifting our allocation. Are there any statistics that justify remaining the course in 70% bonds (Index funds) when the stock market turns the corner and rates increase ?Perhaps my assumption of the beating in the bond index funds during better times is incorrect, but it has always been my understanding that bonds decline as interest rate incline.
I would appreciate your thoughts .
I think you missed the stock market "turning the corner" a couple of years ago. Why do you think the next turn will be up and not down?

What signs do you see of the economy improving?

Why are interest rates more likely to increase now than a year ago? Two years ago?

There are times when no matter what you do, you lose. This may be one of those times.

Paul

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Re: Change in the Economy

Post by The Wizard » Sun Aug 26, 2012 3:50 pm

Some bond FUNDS, like VBILX, pay monthly dividends on your holdings.
So if interest rates go up a small step, then the $1000 a month I'm getting now will gradually ramp up
to $1500 a month over the next 6 years as new issues replace old ones in the fund.
What's not to like???
Attempted new signature...

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Re: Change in the Economy

Post by Call_Me_Op » Sun Aug 26, 2012 4:00 pm

steve_14 wrote:
Johm221122 wrote:Use CD's,short term bond funds,I bonds,individual bonds or stable value funds
Best wishes
john
+1 exactly what I'd do.
+2 makes 3 of us. I would add EE bonds as well, since they have a put option and cannot lose nominal value. In place of a short-term bond fund, I use short-term brokered CD's.
Best regards, -Op | | "In the middle of difficulty lies opportunity." Einstein

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Re: Change in the Economy

Post by GoldRu$h » Sun Aug 26, 2012 10:54 pm

woodedareas wrote:Since I am new to this forum . I have a question that arose today with several friends of mine who are about 70 years old. If we have an assest allocations of about 70% in bonds and about 30% in equities and are using the index funds, what adjustment do we make when the economy improves and interest rates escalate. Our 70 % in bonds will take a beating and our limited exposure in equities will not off-set our losses.Our age precludes shifting our allocation. Are there any statistics that justify remaining the course in 70% bonds (Index funds) when the stock market turns the corner and rates increase ?Perhaps my assumption of the beating in the bond index funds during better times is incorrect, but it has always been my understanding that bonds decline as interest rate incline.
I would appreciate your thoughts .
You are assuming that the economy is going to improve? Peter Schiff and Mike Maloney think otherwise.

Generally you have a financial goal, which might be based on such things as your age. Based on that goal you then decide how much risk tolerance you have and then invest accordingly. As the market changes (spikes up or crashes) you make allocation adjustments.

Bonds have risk too. Yes, it is a fact that when interest rates go up, bonds fall in value.
Last edited by GoldRu$h on Sun Aug 26, 2012 11:12 pm, edited 1 time in total.

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Re: Change in the Economy

Post by cheese_breath » Sun Aug 26, 2012 11:04 pm

Call_Me_Op wrote:
steve_14 wrote:
Johm221122 wrote:Use CD's,short term bond funds,I bonds,individual bonds or stable value funds
Best wishes
john
+1 exactly what I'd do.
+2 makes 3 of us. I would add EE bonds as well, since they have a put option and cannot lose nominal value. In place of a short-term bond fund, I use short-term brokered CD's.
+3 makes 4 of us. I have around 30% in Vanguard TSM and the rest in TIAA Traditional earning 3%. I'm taking my total RMD out of my Vanguard TSM this year and putting it in taxable Vanguard TSM. That way I can maintain the same allocation and not disturb the TIAA Traditional.
The surest way to know the future is when it becomes the past.

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Phineas J. Whoopee
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Re: Change in the Economy

Post by Phineas J. Whoopee » Mon Aug 27, 2012 12:51 pm

woodedareas wrote:Since I am new to this forum . I have a question that arose today with several friends of mine who are about 70 years old. If we have an assest allocations of about 70% in bonds and about 30% in equities and are using the index funds, what adjustment do we make when the economy improves and interest rates escalate. Our 70 % in bonds will take a beating and our limited exposure in equities will not off-set our losses.Our age precludes shifting our allocation. Are there any statistics that justify remaining the course in 70% bonds (Index funds) when the stock market turns the corner and rates increase ?Perhaps my assumption of the beating in the bond index funds during better times is incorrect, but it has always been my understanding that bonds decline as interest rate incline.
I would appreciate your thoughts .
Hi woodedareas, and if nobody has said so yet, welcome to the forum.

There have been several responses but I'd like to address your question in the terms you asked it.

Part 1: "Perhaps my assumption of the beating in the bond index funds during better times is incorrect, but it has always been my understanding that bonds decline as interest rate incline."

Your basic understanding is correct, that if prevailing interest rates increase the market value of a portfolio of already-issued bonds decreases.

On the other hand, the drop in market value does not decrease the interest paid by those bonds. They'll keep paying interest on a regular schedule until they mature. In a bond fund, with a large number of securities of different types and maturities, of course the dividends will fluctuate as they always do with funds.

The degree of market value drop depends on how much time remains until the bonds mature. Let's imagine a $1000 bond which dropped to a value of $950 due to increasing rates. As it gets closer and closer to maturity, its value gets closer and closer to $1000, because that's the amount of principal the bond issuer will pay back. This is the reason some posters are suggesting short duration bonds and CDs, which will minimize the potential decrease.

Furthermore, in a fund, the managers will take that returned principal and invest it in a new bond, whose yield will be based on the newer, higher rates.

Now, let's focus on one number associated with bond funds, the "average duration." There are several ways to look at it, but the way germane to your question is "the point of indifference," that is to say, the number of years until the higher yield (due to higher interest rates) makes up for the loss in market value. Beyond that point, you'll be better off than you would have been with no interest rate increase. The calculation does not depend on how large the interest rate increase was; the point of indifference comes out the same.

The calculation assumes you are reinvesting interest, but even if you aren't, the point remains that as older bonds are replaced the payouts from the fund will catch up with the interest rate increase.

As an example, the Vanguard Total Bond Market Index Fund has an average duration of 5.1 years. That means with reinvested dividends, it would take about 5 years of the higher yield from higher rates for you to get to even, and beyond that time you'd be ahead.

Now let's look at your question about action.

Part 2: "... what adjustment do we make when the economy improves and interest rates escalate?"

If you and your friends are slowly drawing down your portfolios to fund your retirements, it isn't clear that a temporary drop in the net asset value of a bond fund requires much if any response. It would make a difference if you are selling a large percentage of your bond holdings each year to spend, but if you are down in the 4% range, the differences should average out over time. Maybe all you would do, in the scenario you described, would be to sell a bit more of your stock funds than bond funds, simply aiming at maintaining the 70% bond to 30% stock ratio you chose to begin with.

You can read more about bonds in the Boglehead's wicki. You could start with:
http://www.bogleheads.org/wiki/Category:Bonds

I know this post is already long, but I'd like to close with a quote from Jack Bogle:

You May Have a Stable Principal Value or a Stable Income Stream, But You May Not Have Both.

It's the 9th Pillar of Wisdom:
http://www.vanguard.com/bogle_site/april272001.html

Please let us know whether what I've written helps clarify things for you and your friends.

PJW

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Re: [holding high bond allocation when interest rates rise]

Post by Alex Frakt » Mon Aug 27, 2012 2:30 pm

The basic point of Investing in retirement is to maintain sufficient income. If you hold a lot of bonds, an increase in interest rates will result in a decrease in the paper value of your portfolio, but it won't decrease the income the bonds produce each month. Actually, over time it will increase it as the underlying bonds mature and get rolled over to higher interest bonds. So, if you are receiving enough income to live comfortably, don't worry about it.

Note that once you clear the hurdle of having sufficient income, it's your call as to how to invest the rest. If you want to try to maximize your estate, you should probably go for a larger allocation to equities, at least after setting some amount aside to cover any "what if" scenarios.

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Re: [holding high bond allocation when interest rates rise]

Post by staythecourse » Mon Aug 27, 2012 8:01 pm

Alex Frakt wrote:The basic point of Investing in retirement is to maintain sufficient income. If you hold a lot of bonds, an increase in interest rates will result in a decrease in the paper value of your portfolio, but it won't decrease the income the bonds produce each month. Actually, over time it will increase it as the underlying bonds mature and get rolled over to higher interest bonds. So, if you are receiving enough income to live comfortably, don't worry about it.

Note that once you clear the hurdle of having sufficient income, it's your call as to how to invest the rest. If you want to try to maximize your estate, you should probably go for a larger allocation to equities, at least after setting some amount aside to cover any "what if" scenarios.
Well said and agree 100%.

Good luck.
"The stock market [fluctuation], therefore, is noise. A giant distraction from the business of investing.” | -Jack Bogle

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Re: Change in the Economy

Post by midareff » Mon Aug 27, 2012 8:14 pm

peppers wrote:http://www.bogleheads.org/forum/viewtop ... 1&t=101649

Check out Nisiprius' fine work.
It is excellent work and well though out. I believe there is another way to look at this. .. at least for bond fund holders. If you hold an intermediate term fund with a duration of 5 years and an SEC interest rate of 2.5% and the interest rate rises 1% your fund has lost 5% of its value and the interest rate it pays is now 3.5%. The fund recovers full value in 1.43 years and now pays an SEC of 3.5% Lets take a short term investment grade fund with a duration of 2.3 years and an SEC of 1.8%. Interest rates rise 1% and the fund has list 2.3% of its value but the SEC interest rate paid is now 2.8%. It takes .82 years to recover full value. You can do this exercise for any bond fund and it will be reasonably accurate. When you expect continued rate hikes simply continue the execise to completion.

Hope it helps. :oops:

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Re: [holding high bond allocation when interest rates rise]

Post by midareff » Mon Aug 27, 2012 8:15 pm

staythecourse wrote:
Alex Frakt wrote:The basic point of Investing in retirement is to maintain sufficient income. If you hold a lot of bonds, an increase in interest rates will result in a decrease in the paper value of your portfolio, but it won't decrease the income the bonds produce each month. Actually, over time it will increase it as the underlying bonds mature and get rolled over to higher interest bonds. So, if you are receiving enough income to live comfortably, don't worry about it.

Note that once you clear the hurdle of having sufficient income, it's your call as to how to invest the rest. If you want to try to maximize your estate, you should probably go for a larger allocation to equities, at least after setting some amount aside to cover any "what if" scenarios.
Well said and agree 100%.

Good luck.

and +2

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Re: [holding high bond allocation when interest rates rise]

Post by Munir » Mon Aug 27, 2012 8:37 pm

Alex Frakt wrote:The basic point of Investing in retirement is to maintain sufficient income. If you hold a lot of bonds, an increase in interest rates will result in a decrease in the paper value of your portfolio, but it won't decrease the income the bonds produce each month. Actually, over time it will increase it as the underlying bonds mature and get rolled over to higher interest bonds. So, if you are receiving enough income to live comfortably, don't worry about it.

Note that once you clear the hurdle of having sufficient income, it's your call as to how to invest the rest. If you want to try to maximize your estate, you should probably go for a larger allocation to equities, at least after setting some amount aside to cover any "what if" scenarios.
I am confused.

If one does not reinvest the dividends from a bond fund while the interest rates are rising, does one still have a "recovery" in the bond fund once the duration period is completed? i.e don't you need to reinvest dividends if you want to later come out ahead in a rising rate environment?

In another scenario, isn't it usually advisable to seek total return from bond funds instead of just dividends, and sell them as needed for an income stream instead of trying to live on dividends, and especially if the dividends are not sufficient for your needs? In such a case and if rates rise, then one has to liquidate a larger number of shares of these bond funds because the NAV has dropped. How does one cope in such a situation was the op's question as I understand it- which is also my question. Moreover, shifting to short term instruments like CDs or short term bond funds is usually too late because how can one tell if the interest rates are continuing to rise for a significant period of time vs. a transient blip for which you are supposed to "stay the course"?

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Re: [holding high bond allocation when interest rates rise]

Post by xerty24 » Tue Aug 28, 2012 2:21 am

Alex Frakt wrote:The basic point of Investing in retirement is to maintain sufficient income. If you hold a lot of bonds, an increase in interest rates will result in a decrease in the paper value of your portfolio, but it won't decrease the income the bonds produce each month. Actually, over time it will increase it as the underlying bonds mature and get rolled over to higher interest bonds. So, if you are receiving enough income to live comfortably, don't worry about it.
the danger is that rises in interest rates are often accompanied by rises in inflation. Say you've locked in your money in bonds for 5 years at 2-3% and inflation and interest rates jump to 5%. While you aren't losing money per se, since your bonds still pay out as promised, you are losing purchasing power which is basically the same thing. Never mind that presently 10 year treasuries or TIPS are providing negative real rates of return with inflation running 2-3% presently, so very likely you were already in a losing situation, but there is still risk for nominal bonds that it could turn into a worse one.
No excuses, no regrets.

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Re: [holding high bond allocation when interest rates rise]

Post by hazlitt777 » Tue Aug 28, 2012 7:49 am

Munir wrote:
Alex Frakt wrote:The basic point of Investing in retirement is to maintain sufficient income. If you hold a lot of bonds, an increase in interest rates will result in a decrease in the paper value of your portfolio, but it won't decrease the income the bonds produce each month. Actually, over time it will increase it as the underlying bonds mature and get rolled over to higher interest bonds. So, if you are receiving enough income to live comfortably, don't worry about it.

Note that once you clear the hurdle of having sufficient income, it's your call as to how to invest the rest. If you want to try to maximize your estate, you should probably go for a larger allocation to equities, at least after setting some amount aside to cover any "what if" scenarios.
I am confused.

If one does not reinvest the dividends from a bond fund while the interest rates are rising, does one still have a "recovery" in the bond fund once the duration period is completed? i.e don't you need to reinvest dividends if you want to later come out ahead in a rising rate environment?

In another scenario, isn't it usually advisable to seek total return from bond funds instead of just dividends, and sell them as needed for an income stream instead of trying to live on dividends, and especially if the dividends are not sufficient for your needs? In such a case and if rates rise, then one has to liquidate a larger number of shares of these bond funds because the NAV has dropped. How does one cope in such a situation was the op's question as I understand it- which is also my question. Moreover, shifting to short term instruments like CDs or short term bond funds is usually too late because how can one tell if the interest rates are continuing to rise for a significant period of time vs. a transient blip for which you are supposed to "stay the course"?
My understanding is that if you do not reinvest the interest, the value of the bond fund will still go up but not as fast. This is because the fund will still be reinvesting the bond principle of the maturing bonds in the fund into new higher paying bonds, in this hypothetically rising interest rate environment. So over a period of time one will be able to look back and realize you are better off.

The problem here though is that most people who have, lets say, a million or less, may find the interest on bonds to be inadequate at the current rates to meet living expenses, even if rates go up a little. Therefore they may be liquidating the principle of their bonds funds too, and in this case, rising interest rates will not benefit them.

Thus the dilemma of the original poster who asks us how to time the bond market. I don't think that is a game most of us can win at so I would suggest at best tweaking ones bond allocation such that overall it has a little shorter duration. I think this is called strategic asset allocation but it is a controversial and problematic method. Perhaps the best is to put all ones bonds into the total bond index fund or to arrange all ones bonds so that they mimic this type of duration and just let it ride.

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Re: [holding high bond allocation when interest rates rise]

Post by jlj » Tue Aug 28, 2012 9:04 am

Wow. PJW, you did an outstanding answer of OP's questions and helped me better understand bond dynamics. Thank you.

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Re: [holding high bond allocation when interest rates rise]

Post by richard » Tue Aug 28, 2012 9:51 am

Adding to the excellent replies from Phineas and Alex, the effect of an interest rate rise also depends on whether you're reinvesting interest and whether you're selling principal. If you are spending interest, selling bonds or both, then it will take much longer for higher interest payments and replacing low rate old bonds with higher rate new bonds to restore the value of your portfolio.

If you are spending some or all of the interest, but not selling principal, income will remain steady and eventually increase following a rate rise. Obviously, selling bonds will decrease the interest earning capacity of your portfolio.

Using shorter term (which almost always means lower duration) bonds will lessen any ill effects from rising rates, but almost always means earning less interest. Depending on the path of interest rates, the extra interest from longer term bonds could easily make up for any principal loss.

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Re: [holding high bond allocation when interest rates rise]

Post by Alex Frakt » Tue Aug 28, 2012 10:03 am

Munir wrote:I am confused.

If one does not reinvest the dividends from a bond fund while the interest rates are rising, does one still have a "recovery" in the bond fund once the duration period is completed? i.e don't you need to reinvest dividends if you want to later come out ahead in a rising rate environment?
That's two questions. Buying a bond fund with a set duration is no different from buying a bond ladder with the same duration. As long as you don't sell part of your fund, the underlying bonds are continually maturing, being redeemed at par and the money reinvested for you at current rates. So if you hold out for the fund duration after interest rates stabilize, you should suffer no loss of principal. To receive an immediate advantage from higher rates (as opposed to just offsetting the loss in NAV), you will need to buy higher rate bonds from the outset, either through rebalancing or reinvesting dividends.
Munir wrote:In another scenario, isn't it usually advisable to seek total return from bond funds instead of just dividends, and sell them as needed for an income stream instead of trying to live on dividends, and especially if the dividends are not sufficient for your needs? In such a case and if rates rise, then one has to liquidate a larger number of shares of these bond funds because the NAV has dropped. How does one cope in such a situation was the op's question as I understand it- which is also my question. Moreover, shifting to short term instruments like CDs or short term bond funds is usually too late because how can one tell if the interest rates are continuing to rise for a significant period of time vs. a transient blip for which you are supposed to "stay the course"?
In this hypothetical, rising rates as a result of an improving economy, the answer will be to sell stocks instead of bonds. We've already seen a few years of rising stock prices. For a more general answer, if the interest payments and dividends generated by your holdings are not sufficient to meet your income needs, you may want to explore a buckets approach. For example, put 1 year of income requirements in a money market fund and 4 years in short term bonds, with the rest in stocks and intermediate term bonds (or total bond). Direct all interest and dividends to the money market fund. At the end of each year, refill your money market fund from your stocks and/or intermediate term bonds if they have had a positive year (and rebalance if there is any surplus), otherwise from the short term bonds. This approach gives you 5 years to wait out economic downturns before you have to start selling your long term holdings at a loss. Note, for this approach to outperform a non-bucket approach, asset classes will have to exhibit mean reversion over a multi-year timeframe. I happen to believe very strongly that they do and will continue to do so. Bill Bernstein and Jack Bogle appear to feel so as well.

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Re: [holding high bond allocation when interest rates rise]

Post by Munir » Tue Aug 28, 2012 11:48 am

Thank you, Alex, for a clear and thorough reply to the questions I raised.

On a related issue, the Total Bond Market Fund, as I understand it, is really made up of three buckets: short term bonds, intermediate, and longterm, which all average to an intermediate duration. By itself, it would not serve the purpose of the plan Alex outlines because the dollars are not separated into individual buckets.

However, also in the scenario mentioned above, one can hold the Total Bond Market Index and sell stock fund shares as a second option that Alex mentioned. This would allow holding all (or most of) one's fixed income in one or two intermediate bond funds as long as one is ready to sell shares of a stock fund when higher rates temporarily lower the NAV of the bond funds for the duration of the bond funds (hopefully).
Last edited by Munir on Tue Aug 28, 2012 12:39 pm, edited 1 time in total.

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Re: [holding high bond allocation when interest rates rise]

Post by Phineas J. Whoopee » Tue Aug 28, 2012 12:27 pm

jlj wrote:Wow. PJW, you did an outstanding answer of OP's questions and helped me better understand bond dynamics. Thank you.
Thank you for saying so.

PJW

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Re: Change in the Economy

Post by Phineas J. Whoopee » Thu Aug 30, 2012 7:21 pm

midareff wrote:
peppers wrote:http://www.bogleheads.org/forum/viewtop ... 1&t=101649

Check out Nisiprius' fine work.
It is excellent work and well though out. I believe there is another way to look at this. .. at least for bond fund holders. If you hold an intermediate term fund with a duration of 5 years and an SEC interest rate of 2.5% and the interest rate rises 1% your fund has lost 5% of its value and the interest rate it pays is now 3.5%. The fund recovers full value in 1.43 years and now pays an SEC of 3.5% Lets take a short term investment grade fund with a duration of 2.3 years and an SEC of 1.8%. Interest rates rise 1% and the fund has list 2.3% of its value but the SEC interest rate paid is now 2.8%. It takes .82 years to recover full value. You can do this exercise for any bond fund and it will be reasonably accurate. When you expect continued rate hikes simply continue the execise to completion.

Hope it helps. :oops:
Hi midareff,

I'm not sure how you get full recovery in 1.43 years for a fund with an average duration of 5.1 years.

Or maybe the oops icon meant you weren't being serious and I failed to realize that?

Yes, I do understand that .035 x 1.43 = .050, but are you taking into account the fact that the fund would still have been earning interest during that time even without an increase in prevailing rates?

Would you be willing to show your work?

:confused

PJW

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