The year to date (ytd) return for long-term treasuries has been outstanding: the Vanguard long-term government bond etf (VGLT) has a ydt return of 17.8% as of September 22, 2010. Vanguard’s extended duration treasury etf (EDV) has returned 26.8%. Meanwhile Vanguard’s short term treasury etf (VGSH) has returned only 2.36%.
Why is there such a large difference in the return of these different time horizon bond etfs? The return obtained from investing in bonds is driven by the yield of the bond and the change in the bond’s value. Assuming there is no change in the credit worthiness of the borrower, the change in a bond’s value is primarily driven by interest rate changes and the duration of the bond.
Most people know that when interest rates drop, bond prices rise. The reason for this is fairly intuitive. If you own a bond that pays, say 6% and the interest rate drops to 5%, you accrue an additional 1% premium on the money you lent relative to what someone can lend money for at current market rates. This makes your 6% interest rate bond more valuable, causing the price to increase to a point where the yield drops to current yields on similar bonds. A similar mental exercise demonstrates the opposite happens when interest rates rise.
The sensitivity of the price change in the bond is related to the duration of the bond. The duration of a bond corresponds to the amount of time before the bond will be repaid. Longer-term bonds near the beginning of their life have longer durations, making them more sensitive to interest rate movements, while shorter-term bonds have lower duration making them less sensitive to interest rate changes.
To simply approximate the change in bond prices caused by a change in interest rates you can multiply the change in the interest rate by the duration of the bond. If the bond is a bond fund instead, use the average duration of the bond fund that is listed under the summary information of the bond fund. We’ll show you how to do this below.
Figure 1 shows the interest rates for different US treasury maturities for January and August 2010. As you can see, interest rates dropped significantly for mid and long-term bonds.
Let’s apply the simple formula of multiplying duration by the change in the interest rate to examine the change in bond fund prices. The Vanguard long-term government bond etf (VGLT) has an average duration of 14.2 years. Interest rates for 15 year treasuries during the period of January to August dropped around 1%. Using the simple formula above, we calculate the percent change in the fund price as 1%/year*(14.2 years) = 14.2%. This 14.2% is due to the change in the interest rate. The bond fund also experienced a yield of approximately 2.5%, giving a total approximated change in the return of the bond fund of 16.7% (ytd). In actuality the bond fund had a ytd return of 17.8%. Recall that the simple formula is an approximation, owing to a difference between the actual and the approximated return.
Recall that the return of the Vanguard short-term government bond etf (VGSH) was much less. The average duration of this etf is only 1.8 years and the change in interest rates for 2 year treasuries is also less, dropping just .47% compared to the 1% for 15 year maturities. The approximated change due to the interest rate is just .85% (.47*1.8) and the yield is also less at .3% giving an approximated ytd return of 1.15%, which is less than the actual return of 2.36%.
While this math is important to some of us, the message for most investors is quite simple: make sure you are diversified relative to duration in the bond portion of your portfolio. You should make sure your bond fund or your bond portfolio holds long-term bonds, short-term bonds and intermediate-term bonds.
Most of us are anticipating rising interest rates and inflation when the economic recovery strengthens. Near the beginning of the year, the recovery of the economy looked imminent, causing many to decrease the duration in their bond portfolios. Yet exactly the opposite happened. Interest rates dropped and long-term bonds have had excellent returns ytd. Betting on outcomes can be dangerous, and it is often better to stay diversified. A portfolio equally weighted across Vanguards short, intermediate and long-term bond funds would have returned 9.91%. That’s not as good as the 17.8% of the long-term bond etf, but it’s also a lot better than the 2.36% short-term bond etf. If you don’t want to manage the diversification of your bond portfolio, explore using a total bond market mutual fund or ETF.