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By Miriam Sjoblom, CFA | 05-20-2010 12:21 PM

Volpert: Shorter May Not Be Better When Rates Rise

The Vanguard bond manager says the very steep yield curve actually makes it more attractive to be in intermediate bonds rather than short-term bonds as rates rise.

Miriam Sjoblom: Hi, I'm Miriam Sjoblom, a mutual fund analyst with Morningstar. I'm here today with Ken Volpert, who's the head of Vanguard's Taxable Bond Group. Thanks for joining us, Ken.

Ken Volpert: Oh, you're welcome. Thank you.

Sjoblom: Well, a lot of investors are concerned about rising rates and how that will impact their bond holdings these days. One of the things you hear that's conventional wisdom is if you're concerned about rising rates, then you should shorten your bond portfolio, invest in short-term bonds.

But that's not necessarily the case today, is it? So I'd like, maybe, to talk a little bit about, what is the market expecting will happen with interest rates? What's your outlook? We'll start there.

Volpert: Yeah. Basically, duration, when people talk about duration of a bond fund, they're usually talking about how volatile the bond fund is for a parallel change in interest rates, where interest rates, whether it's a 2-year or a 5-year or a 10-year, move up or down by the same amount.

In a period like we have right now, where we're coming out of a deep recession, the yield curve actually gets very steep, much steeper than normal. So what happens is, as we come out of that recession, the yield curve flattens out.

The way a yield curve flattens, if it's very steep now and it flattens out, the short end actually goes up more in yield than the intermediate and the longer end. So it's not just a matter of the duration, it's also a matter of how much the yield changes relative to that duration.

So, in this case, our expectation is that the yield curve is going to flatten a lot over the course of the next couple of years. So, actually, short bonds, while they have a lower duration, they have much less yield to offset the rising prices that they may encounter. When the yield does rise, it's going to rise considerably more than it does in the intermediate or the long end.

So our view is that, actually, the very steep yield curve is actually making it a little bit more attractive to actually be in the intermediate part of the curve rather than the short part of the curve. In the intermediate, you're getting a higher yield. In the intermediate, the actual increase in yield is going to be less as the yield curve flattens.

Sjoblom: So, if you move short right now, in other words, there's not much income there to offset potential price declines when the Fed eventually does step in.

Volpert: Exactly right. That's right.

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