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Vanguard Spices Up Bond Sleeve of Its Target-Date Funds

Firm hopes to launch long-awaited international-bond index fund in first half of 2013. 

David Falkof, 02/06/2013

Vanguard will add foreign bonds to its target-date and asset-allocation fund of funds for the first time. The firm will allocate 20% of the target-date bond sleeve to hedged foreign bonds and will make the same allocation change to its LifeStrategy and Managed Payout funds. The funds will use the new Vanguard Total International Bond Index, which Vanguard intends to launch by the end of the second quarter, to get the exposure. The family also will change the way the target-date funds get Treasury Inflation-Protected Securities exposure by swapping Vanguard Short-Term Inflation-Protected Securities Index VTIPX for Vanguard Inflation-Protected Securities VIPSX. Lastly, the target-date funds will no longer invest in Vanguard Prime Money Market. The total fixed-income allocations of the target-date series will remain the same.

Vanguard said the changes will further diversify the fixed-income exposure of these funds, which can help reduce volatility. Previously the Target Retirement funds invested solely in the investment-grade U.S. bond fund Vanguard Total Bond Market II Index VTBIX for most of their glide paths before adding small allocations to Vanguard Inflation-Protected Securities and Vanguard Prime Money near their retirement dates. In a recent research paper, Vanguard found that international bond prices respond to factors uncorrelated with the U.S. bond market, which suggests foreign bonds can help diversify a portfolio of U.S. bonds. The firm also determined that exposure to foreign-currency fluctuations can overwhelm the diversification benefits of the underlying foreign bonds. Therefore, the new Vanguard Total International Bond Index will hedge its currency exposure back to the U.S. dollar. The fund will track the Barclays Global Aggregate ex-USD Float Adjusted RIC Capped Index (USD Hedged), which caps single bond issuers at 20% of assets, according to a recent regulatory filing. Vanguard initially filed for the fund in October 2011, in which the fund was to track the uncapped version of the Barclays foreign bond index. The family first hoped to launch the Total International Bond Index and an emerging-markets government-bond index fund last year, but it postponed the rollout.

The addition of Vanguard Short-Term Inflation-Protected Securities Index also is intended to lower volatility for the target-date funds near the retirement date. The fund was launched in October 2012 as a less interest-rate-sensitive version of Vanguard Inflation-Protected Securities. The short-term fund has a duration of 2.5 years, whereas its sibling has a duration of 8.5 years. In a press release, Vanguard said short-term TIPS historically have provided a higher correlation to realized inflation with less sensitivity to interest-rate changes than have longer-term TIPS.

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David Falkof is a mutual fund analyst at Morningstar.
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