Bond fund investors have been on a pretty good ride. Using the Vanguard Total Bond Market Index Fund (MUTF: VBMFX) as an indicator of what bond fund investors have earned, the fund reports one and three year total return rates of 7.96% and 7.36% respectively, through the end of the third quarter. The bulk of the returns have been the result of an appreciation in bond prices as interest rates have declined. In the past year VBMFX investors have earned 38.4 cents per share in dividends and have seen the fund’s share price increase by 58 cents.
If you are invested in bond funds, you have seen similar results — but may be wondering where your returns will go from here. The Vanguard Total Bond Market Index Fund is now sporting a standard SEC yield of 2.45% and a dividend distribution yield of 3.23%. Over the course of the year the monthly distribution has fallen by 12%. So can yields continue to decline and prices increase?
The run-up in bonds and bond fund share prices have been due to the steady decline in interest rates across the yield curve. If interest rates stop declining and remain flat, bond fund share prices will remain relatively level and the distribution yields will move towards the reported SEC yields. A worse scenario for bond fund investors is a shift to rising interest rates. Increasing market rates will result in falling bond prices and bond fund share prices. As a bond fund investor you probably would like to know how much the rising rates will affect the value of your bond fund account.
Bond mutual funds provide two statistics about a fund that give investors an indication of the future return of a particular fund. The statistics are a bond fund’s average maturity and average duration. These averages combine the prices and yields of a fund’s portfolio into two informative pieces of information.
The average maturity is what it sounds like: an average of the time to maturity of all of the bonds in a particular fund’s portfolio. A fund with a longer average maturity will have greater share price fluctuations in relation to changing interest rates than a fund with a shorter average maturity. The average maturity also tells you where along the yield curve the fund is generating its interest rate.
The average duration calculation takes into account the time value of money and projected incoming interest payments as well as the maturity date of the bonds. The average duration value can be used as an indicator of how much the share price of a bond fund will change for a 1% change in interest rates.
Here are the average maturity and average duration for a couple of the Vanguard bond funds:
Vanguard Long-Term Bond Index Fund – Ave. Maturity 22.9 years; Ave. Duration 13.4 years
Vanguard Intermediate-Term Bond Index Fund – Ave. Maturity 7.4 years; Ave. Duration 6.4 years
From this information you can expect the intermediate term bond fund to decline 6.4% in value if interest rates increase by 1% and the long term bond fund will decline by twice as much for the same change in rates. A 13% share price decline in a fund with a 4% dividend yield will take quite a while for investors to get back to break even. Remember, interest rates may not change at the same rate equally across the yield curve.
The websites for the bond funds you own will have the current average maturity and duration available in the portfolio statistics or data section. Look up the information for your bond funds and compare the yield you are receiving in relation to the reported duration(s). If you are forecasting higher bond interest rates, you should be looking for shorter portfolio durations.
You can also check what the fund’s portfolio manager is doing by watching the duration value over time. Is the fund compressing the duration, indicating defensiveness against rising rates or is the duration expanding in search of more yield?
