In 1972 you could purchase a constant maturity 10 year T-Note fund yielding 6.4%. Interest rates almost doubled over the coming 8 years, but this investor still averaged 2.6% returns per year because the high yield offset the interest rate risk. To be wonky – the duration, or interest rate sensitivity of the fund was about 7.5. Meanwhile, the fund was yielding 6.4% when it was purchased in 1972. This means that if interest rates go up by 1% the bond will lose 7.5% in principal. But it is also earning 6.4% per year so this bond earns a -1.1% total return in year one. In the case of the 1970s 10 year interest rates rose from 6.4% to 13% in 1980. Despite this, a constant maturity 10 year bond fund had an average yield of 8.4% over this period. So the average interest rate more than offset the duration and resulted in positive nominal returns during this period. This point where yields offset interest rate risk can be thought of as a sort of escape velocity where rising interest rates still hurt bond prices, but the starting or average yield has escaped from most of the potential negative impact of interest rate risk.
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