by Dan Wiener | June 6, 2013 2:55 pm
For the investor who is only focused on growth and can stomach volatility, stocks have proven to be the best way to grow your money over time. But if you are looking to control your risk and help smooth out the ride, bonds should have a place in your portfolio.
However, as I’ve been explaining in my Bonds 101 articles here and in my newsletter, The Independent Adviser for Vanguard Investors, there are several factors to consider before you pick a bond or bond fund to invest in.
When it comes to bond funds, the Vanguard formula is tried and true: Keeping costs low doesn’t force the portfolio managers to reach for yield, instead allowing them to build plain-vanilla portfolios that have been very competitive from both a yield and a total return perspective. I have confidence in Vanguard’s ability to continue to execute these strategies well, both on its indexed and actively managed funds. (Remember, when it comes to bond funds, Vanguard does manage a significant portion of the in-house assets actively. Where it doesn’t manage the assets on its own, the firm has partnered with Wellington Management.)
That said, there are some areas of the bond market I prefer over others, and some that I would avoid entirely:
I use the Vanguard Short-Term Investment-Grade Fund (VFSTX) as well as the Vanguard GNMA Fund (VFIIX) as higher-yield shock absorbers/cash substitutes in my newsletter’s Model Portfolios, and would recommend them in that role for most any portfolio invested for the long haul. There is no substitute for a money market fund for cash that you need to spend in the near future … but for cash that you don’t need to spend tomorrow, this remains a solid choice for investors looking to boost yield on “dry-powder” holdings.
The 2008 credit market debacle tested this claim — and my faith in the fund. Because it doesn’t invest more than a smidgen in government-backed securities (only 15% or so), Short-Term Investment-Grade took a beating during that brief episode, losing 7.6% at its worst. But its recovery was swift, my confidence was restored, and I remain a huge fan.
Today, though, I am keeping an eye on its yield, currently at 1.06%. While still a nice pickup over Vanguard Short-Term Treasury Fund‘s (VFISX) 0.11%, as Short-Term Investment-Grade’s yield keeps grinding lower, we are getting less compensation for the credit risk, and at some point, it might signal a sale — but not yet.
There’s nothing really wrong with the vanilla Vanguard Intermediate-Term Treasury Fund (VFITX) or its slightly broader-focused ETF cousin, Vanguard Intermediate-Term Government Bond ETF (VGIT). In true Vanguard fashion, it has low costs and delivers what it says it will. Treasury bonds have also consistently provided a place to protect your assets when the stock market has sold off. When conditions are right, intermediate maturity funds can offer you a terrific risk/return combination, generating 70% to 80% of the return you’d get from a long-term fund with only half the interest-rate risk.
However, as with all Treasury-focused funds, the yield here is really low, only 0.8%. That is below the 1.06% yield on Short-Term Investment Grade, and here you have at least twice the interest-rate risk. I don’t see any value in the Treasury market.
Given where interest rates are right now, I’d go for the higher yields and better returns from Vanguard Intermediate-Term Investment-Grade Fund (VFICX).
As with Intermediate-Term Treasury, this fund generally gives the advantage of decent returns with only mid-range interest-rate risk. The difference is that this actively managed fund typically focuses on corporate bonds, with less than 10% of the portfolio in interest-rate-sensitive government-backed bonds. The result is a higher yield — 2.18% compared to 0.8% for Intermediate-Term Treasury, or a pickup of 138 basis points.
If I had to buy just one straight intermediate-term bond fund, this would be it.
Investors in Vanguard Total Bond Market Fund (VBMFX) can essentially buy the entire bond market at rock-bottom cost. Whether that’s appealing in today’s interest-rate environment is another question entirely.
The portfolio holds more than 5,800 positions in an effort to track an index of over 8,000 bonds, the Barclays U.S. Aggregate Bond index. Its assets are spread among corporate bonds (about 30%), Treasury and agency bonds (45%) and mortgage-backed securities (25%). After more than two decades, the fund has proven a worthy competitor to many actively managed funds, and its worst decline was a 5.8% loss over seven months in 1987, which was recovered in four months.
VBMFX is a fine fund. However, as I’ve discussed, the portfolio’s growing allocation to Treasury bonds has me concerned, and given how low yields are today, I don’t see how the fund can repeat its performance of the past decades in the years ahead. I think the investment-grade option will give investors the biggest bang for their buck during the next few years.
Despite lackluster performance in the Vanguard GNMA Fund (VFIIX) this year, I continue to have confidence in this fund.
GNMAs (often referred to as Ginnie Maes) are bonds backed by mortgages. The Government National Mortgage Association buys home mortgages from banks, combines them into large packages of loans with roughly the same maturities and interest rates, then resells them to institutional investors. The result is a bond with a government guarantee but a relatively higher yield because it isn’t as straightforward as a Treasury bond.
GNMAs have a unique risk, called “prepayment risk,” in that the underlying mortgages can be repaid early. If interest rates fall, homeowners might refinance, and if a mortgage with a higher rate of interest is paid off and replaced by one with a lower rate, the GNMA bond holding that original mortgage returns the principle to the bond owner — it no longer holds that higher-yielding mortgage. So when interest rates (and particularly mortgage rates) are falling, investors tend to shun GNMAs. But in rising-rate environments, those mortgages stay put, and the fund’s extra yield helps to carry the day in the total return race.
In any case, there’s less prepayment risk in this fund than in most GNMA funds, as manager Mike Garrett of Wellington focuses on bonds whose underlying mortgages are “seasoned,” or less likely to be repaid early.
Because GNMAs are less-understood, many investors don’t know how to use them in a portfolio. Vanguard’s online “planning” tool recommends other intermediate-term bond funds in place of GNMAs. And Vanguard’s personal financial planning team rarely, if ever, recommends the fund because their computers just don’t get it. This creates opportunity.
By spending a little extra time to understand GNMAs, you can pick up yield compared to Total Bond Market — 2% vs. 1.51% — while also reducing interest-rate risk.
Editor Dan Wiener and Research Director Jeffrey DeMaso publish The Independent Adviser for Vanguard Investors, a monthly newsletter that keeps abreast of recent developments at Vanguard, and the annual FFSA Independent Guide to the Vanguard Funds.
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