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Author: Lokicious Big gold star, 5000 posts Feste Award Nominee! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 35357  
Subject: Re: Vanguard Bond index fund ok now? Date: 9/21/2003 9:25 AM
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"Is it ok to invest in the Vanguard Inter-Term Bond Index fund (VBIIX) and the Vanguard Total Bond Market Index fund (VBMFX) right now, or will I lose alot of money when interest rates go back up again?"

For the Intermediate Fund, the yield is currently 4.5% and the "average duration"
(which measures interest rate risk) was 6 years as of end of August.

For the Total bond fund, the yield is listed as 4.16%, with duration of 4.6 years. Because of some trick the fund does occasionally to match the Lehman Index the yield was confusing for a while, but this sounds about right (both the yield and duration are larger than they had been when interest rates were at their lowest, but not substantially).

Duration is key to evaluating risk. With the Intermediate Fund, for every percentage point (100 basis points) relevant interest rates rise, the fund's NAV would lose 6% (multiply duration of 6 times % points changed). To some extent this is mitigated by a rising yield, i.e., if interest rates changed gradually, the average yield would go up .5% over the time it took interest rates to go up 1% (approximation). Bottom line, if over the next 6 years (using duration as the time during which the current holdings work their way through), interest rates go up 1% point, your average annualized yield would be approximately 5%, but you would have a 6% capital loss, so over 6 years your actual total annualized return would be approximately 4% (a small fraction better with reinvested dividends). If interest rates went up 2% points, over 6 years, your average total annualized return would be 3.5%. If rates went up 3% points, it would be 3%, and so on.

With the total bond market index fund, if rates go up 1%, over 4.6 years, your annualized total return would be 3.66% (assuming average yield over 4.6 years of 4.66% with 4.6% capital loss). If rates went up 2% points, your annualized total return would be 3.16%, and so on.

So, as long as you plan on holding at least as long as the fund's duration, you aren't going to lose your shirt (although long term bond funds are more dangerous). The real question is whether you think you can do better with something else. If I can get a 3.6% 5-year CD, I'm getting about the same total return if interest rates go up 1% point and a better return if they go up more than that.
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