Thu, 18 Oct 2012
Vanguard's chief economist, Joe Davis, cautions investors who turn to equities to replace bond income and also offers some vehicles for short- and long-term inflation protection.
Christine Benz: Hi, I'm Christine Benz for Morningstar. With yields as low as they are, many investors are concerned about what lies ahead for bonds. Joe Davis, Vanguard's chief economist, recently sat down with me to share his perspective.
Joe, thank you so much for being here.
Joe Davis: Thank you, Christine.
Benz: One topic I'd like to touch on with you is fixed income. This has been a very vexing part of many investors' portfolios. I think there are a lot of concerns that interest rates could rise. What's your counsel to investors attempting to navigate their fixed-income positions today?
Davis: Great question, Christine. Twofold, the first is that we're really trying to recalibrate return expectations going forward for bond investors. As you mentioned, the past 20-30 years have been actually fantastic return performance in aggregate for fixed income. However, given the initial yield to maturity on many bond portfolios, it is highly, highly unlikely that the returns on, say, the next five or 10 years will mirror those of the past 10 or 15. So, we have to recalibrate return expectations. At the same time, we're also underscoring the strategic role that bonds can play in a portfolio, the diversifying property in a broadly balanced portfolio that, say, might help diversify equitylike volatility. So, again, long-term message, portfolio construction is similar; it's very much the same as we've always have. At the same time the returns that we would expect bonds to provide us are going to be lower in a nominal sense for the foreseeable future.
Benz: Are you concerned that investors in this quest for yield, and it is a very low-yield environment, are perhaps taking on outsized risks with their fixed-income portfolios these days?
Davis: I am. I mean I think it's one of the side effects of monetary policy that [investors] increasingly search for yield and reach for yield in some segments of the bond market. We clearly are seeing that in the high-yield fixed-income arena, both in corporates as well as municipals. Again, I think many investors are doing it with eyes wide open and perhaps are willing to take on greater interest-rate or credit risk. However, I do hope that they do realize that they're doing so in the process. Yield-to-maturity, again, is a good proxy for expected returns, but the higher the yield is also commensurate with higher volatility, and so we have to be appropriate.
I'm even more concerned, however, we're seeing from some investors on, say, a dividend portfolio or an equitylike portfolio, they're equating that as similar to a yield on a bond portfolio, and those are markedly different characteristics in terms of what they may mean for expected returns. So, again, dividend-paying stocks are not bonds and I think that's important for investors to go on. If they're considering such changes eyes wide open, they're adopting a more equitylike portfolio regardless of the nature of the equities themselves.
Benz: And they may have a lot more volatility even in a high-quality equity portfolio than they might have in high-quality bond?
Davis: No doubt. And again, stocks should outperform bonds over the long run, and valuations would suggest that that's a reasonable assertion, at least a decent probably of that occurring. However that comes at a cost of bearing volatility during periods of risk aversion, much like we had this past summer and can very well be in store for next several months. And again, just some more of [having your] eyes wide open and just understand the risk that you're trading off and bearing.
Benz: One other topic I'd like to cover with you Joe is inflation. Inflation, of course, is one of the natural enemies of bonds.
Davis: Yes. It is.
Benz: And you and your team recently did some work where you looked at which categories, which investment types have the best protection against short-term inflation. And you looked at short-term Treasury Inflation-Protected Securities especially and found that they were quite good in terms of hedging short-term inflation, better in fact than a total bond market TIPS product?
Davis: Yes. Again, I think the discussion we all have around inflation protection, inflation hedging is one of the seminal portfolio construction topics in conversations we will have for a decade, regardless of where inflation goes, because of the Federal Reserve policy, our debt backdrop, and also the development of the emerging-markets community. So that said, I think it is important first to have a conversation of what do we mean by inflation hedging or inflation protection because there are really two definitions in the industry: one is an asset or asset class that will correlate in the short term as the highest correlation with CPI or with the consumer price basket.
Benz: And that's what you found with the short-term TIPS?
Davis: And that's what we found in short-term TIPS. And then others are longer-term. They're going to preserve real purchasing power, so equities for example come to mind, and so short-term TIPS there may not fare as well and particularly given where real yields or the inflation-adjusted yields are.
So again, it depends on what the investor wishes to do in terms of inflation protection: Is it a long-term principle accrual or it's a short-term matching with CPI? If it's the latter, you are going to have a greater allocation to TIPS, and not only TIPS, short-term TIPS would actually be higher than REITs, higher than gold, higher than commodity futures and higher than equities.
Benz: Well, Joe, thank you so much for sharing your insights on the fixed-income market.
Davis: Thank you, my pleasure.