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By Jason Stipp | 09-18-2014 04:00 PM

Rise in Rates Not Always Bad for Bond Investors

If you have a long time horizon, the extra income from higher rates will offset short-term losses, says Vanguard's Josh Barrickman.

Jason Stipp: I'm Jason Stipp for Morningstar. After some hiccups in 2013, bond fund investors have come back to bonds as the ever-imminent rise in interest rates has not yet materialized.

Here to offer some perspective on the bond market is Josh Barrickman, head of bond indexing for Vanguard.

Josh, thanks for joining me today.

Josh Barrickman: Thank you. My pleasure.

Stipp: Investors who have been worried for so long about a rise in interest rates must be tired of being worried, because rates have--except for a couple of instances--stayed pretty low and seem like they're stuck there at least for the short to intermediate-term. So, how should investors think about this--investors who are worried about it--given that rates seem so unpredictable? We feel like they have to go up, but they just haven't gone up.

Barrickman: That's just it; I think you touched on it. It's unpredictability. We've said for the last five years that rates have nowhere to go but up, and like you said, except for a 2013 hiccup, we've seen positive bond returns. This just re-emphasizes the point that it's a very difficult thing to do to predict interest rates. We recommend a long-term discipline, stick to your asset allocation, and things will play out well for you.

Stipp: Investors who are looking for more strategic exposure to bonds could consider a fund like the Vanguard Total Bond Market Index, which you manage. How might a fund like that, which has very broad exposure but also some interesting characteristics, perform in different types of environments? What should you know if you were going to buy the index?

Barrickman: The Total Bond Market is benchmarked to the Barclays U.S. Agg, which is composed of Treasuries, mortgages, credit securities, as well as some other securitized products. It has a duration of about five-and-half years, which is going to measure its sensitivity to changes in interest rates. So, for a 100 basis point rise in interest rates, you could expect maybe a 5.5% decline in the price return that you would get in a fund like that. That's of course going to be offset somewhat by the income that's also inherent.

I think what we have to keep in mind, though, is that a rise in interest rates is really not always a bad thing for investors. If you have a long time horizon, a time horizon that's longer than the duration of the fund--so in this case, five-and-half years--you actually benefit from interest rates going up, because you can reinvest at higher and higher yields and earn that interest to recoup some short-term losses.

Stipp: The index overall actually looks different than a lot of the funds in the same category. What kind of bets do you think active managers are taking that have caused them to look different than how the index looks?

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