billyt wrote:There is an interesting question there. Assuming one is holding the fund for their investment lifetime (in other words well past the duration), which is better for the total return over the long run: a dramatic rise in rates that stabilizes at a higher level, or several years of gradually rising rates. I am not sure, but I think a big, one time, rise in rates is better for your total return, but of course might be very disruptive to the markets.
billyt: the big rise is better without a doubt. You can even prove it: a dollar invested in the fund in that scenario earns at least as much interest at any point in time than in the slow rise scenario. It earns more as soon as you begin to reinvest capital. From then on it's just a matter of waiting long enough to make up the difference in NAV loss between the two scenarios, which means duration or less.
We've seen variants of the slow rise scenario in the past: between 6/16/2003 and 6/18/2007 5 year treasury rates rose from a low of 2.08% to a high of 5.18%, against a backdrop of Fed funds rate going from 1% to 5.25%. What happened to Treasury funds? the IT fund VFIUX returned 6.8% between those exact dates, which is not a stellar return for four years, but it's not a disaster either. I wish we had had another year or two of stable
rates to see it actually pull ahead of where it would have been without the rate increase (+8% -ish), but of course the crisis followed and Treasuries were golden for the next couple of years. Edit
: also, the 6.8% number is with perfect timing. If you jumped out 1 month before the low, you have to beat 9.4% returns. If you jumped back in 1 month after the high, you have to beat 8.1%. 3 months after the high, 12.6% but we're entering financial crisis territory which is admittedly unfair.
The point is, it's not that bad
, the funds recover and after every increase they are better investments than they were before.