3. The yield buffer is the lowest in history. In order to understand the impact of longer duration and low yields, let's use a real-life example of one of the largest bond funds today and look back at its history.
According to Morningstar, over the past 30 years, the Vanguard Total Bond fund has experienced six years when the principal loss in the portfolio was more than 2 percent. However, because the income return in each of these years was sizable, no single year resulted in a total return loss greater than 3 percent.
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For instance, in 1987 the rise in interest rates caused the price of the Vanguard Total Bond fund to plummet by a whopping -7.6 percent. Because the income return was so high, at 9.2 percent, the fund still had a total return of 1.5 percent. The income was more than enough to offset the principal loss.
By comparison, the current yield today is a mere 1.8 percent. This, coupled with an effective duration of 5.5, offers the least amount of cushion to offset any rise in interest rates in the fund's history. As an oversimplified explanation of duration, a 1 percent rise in interest rates will cause a 5.5 percent decline to its current principal value.