Question about bond fund duration and current SEC yield

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Kelly
Posts: 251
Joined: Sun Nov 18, 2012 7:39 am

Question about bond fund duration and current SEC yield

Post by Kelly » Sun Aug 21, 2016 10:39 am

Folks

I asked this question earlier in another form and I think it was misunderstood. Or, maybe I don't understand the basics of bond math.

Vanguard's international bond fund has a SEC yield of 0.4% and a duration of 7.8 years. According to Bogleheads wiki duration represents the length of time it would take for the total value of the fund, with dividends reinvested, to be worth exactly what it would have been worth had interest rates not risen.

Where am I wrong in these three scenarios (assumes held in an IRA and interest is reinvested):

1- If rates remain unchanged the annualized return over the 7.8 year duration will be 0.4%.
2- If rates rise, there will be a NAV decline but will be reinvesting at a higher rate and will break even at 0.4% annualized return at the duration.
3- If rates go to zero or negative, NAV will rise, but will be reinvesting at a lower rate and will break even at the same 0.4% annualized return at the duration.

Put another way, how would it be possible to get an annualized rate of return over the duration that is much further from 0.4%?

Many thanks

Kelly

garlandwhizzer
Posts: 1882
Joined: Fri Aug 06, 2010 3:42 pm

Re: Question about bond fund duration and current SEC yield

Post by garlandwhizzer » Sun Aug 21, 2016 12:11 pm

Kelly wrote:
Where am I wrong in these three scenarios (assumes held in an IRA and interest is reinvested):

1- If rates remain unchanged the annualized return over the 7.8 year duration will be 0.4%.
2- If rates rise, there will be a NAV decline but will be reinvesting at a higher rate and will break even at 0.4% annualized return at the duration.
3- If rates go to zero or negative, NAV will rise, but will be reinvesting at a lower rate and will break even at the same 0.4% annualized return at the duration.

Put another way, how would it be possible to get an annualized rate of return over the duration that is much further from 0.4%?
The best estimate of your annualized return over the 7.8 year duration is 0.4%/yr. but that only takes interest payments into account. Total return (interest payments plus change in principal value) will depend on changes in interest rates--how much they rise or fall and the pace at which they rise of fall. There is no way to predict an accurate reliable annualized rate of return on either equities or bonds that have significant duration like 7.8 yrs. Best you can do is estimate and there may be a fairly wide dispersion of results depending on the time frame you hold the fund. Not to mention the trouble in converting nominal returns into real inflation adjusted returns which over 7.8 years may be significant.

What you do know is this: you're getting ridiculously low interest rate payments and singing up for them over a significant duration. Even if rates rise only one percent your loss in principal value is estimated to be 7.8% (7.8 duration X 1 % rise in rates). It may takes a long time for interest payments to make up that loss if they start out at 0.4%/yr. and end up at 1.4%/yr. A lot depends on the time sequence of interest rate rises or falls and the speed with which they change. Take home message: this investment may provide the stability of bonds but isn't going to make you rich. Another take home message: what we humans crave is certainty, knowing exactly what the future is going to offer us in returns which markets do not offer unless you stick with T Bills, short term TIPS, or inflation indexed annuities, none of which offer rates of return that differ significantly from zero at present.

Garland Whizzer

stlutz
Posts: 4543
Joined: Fri Jan 02, 2009 1:08 am

Re: Question about bond fund duration and current SEC yield

Post by stlutz » Sun Aug 21, 2016 12:21 pm

The exact return will depend on factors like the shape of the yield curve, the call provisions of the underlying bonds, and how much interest rates change and when.

The SEC Yield is the number around which the actual return will fall, but it's not a mathematical certainty. It's more accurate to say that your actual return will be in the range of .4%, plus or minus 2% per year.

If you want to get deep into the weeds on the subject, see this thread from last year: viewtopic.php?t=155923

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