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By Christine Benz | 10-03-2013 09:00 AM

Volpert: Less Risk in Intermediate-Term Bonds Than Perceived

Vanguard's Ken Volpert cautions investors about a rise in short-term rates, and also offers his thoughts on the U.S. debt ceiling as well as Vanguard's TIPS, international-bond, and total bond market funds.

Christine Benz: Hi, I'm Christine Benz for Morningstar. I'm here at Morningstar's ETF Invest Conference, and I'm joined by Ken Volpert. He is head of taxable fixed-income investments at Vanguard.

Ken, thank you so much for being here.

Ken Volpert: Thanks, Christine.

Benz: Ken, let's start with the very short term. I'd like to get your take on what the current impasse in Washington means for bonds as well as Treasury bonds, specifically. There's been a lot of concern over that issue.

Volpert: With the Treasury bond market, even though this whole impasse affects Treasury bonds, and the potential default, et cetera, of the U.S. Treasury, investors are flocking to the bonds as a safe haven. Yields have actually come down a fair amount. Anytime there's a lot more of concern about what's happening in Washington, Treasury yields go lower, and Treasury prices go higher, which is counterintuitive, given that it really seems to be a credit issue.

But my expectation is that as get closer to Oct. 17, you will have more concern in risk assets. Credit spreads maybe will widen a little bit; stocks maybe will sell off a little bit. But we've been through this a couple of times already, and the government does seem to need that crisis, need that debt-ceiling deadline to actually sit down and talk and negotiate and come up with some solution. It does seem like the Republicans are battling through and trying to figure out [a solution]. There's a moderate part, and there's a very conservative part of the Republican Party. And it would be interesting to see how that all plays out. But I do expect that by the Oct. 17, maybe the last hour before the deadline that that something will happen.

Benz: Taking a slightly longer-term view, I'd like to get your thoughts on the Fed's beginning to taper its bond-buying program. What's your take on when that is likely to begin?

Volpert: I think what the Fed has indicated--and I think most investors were surprised that they deferred the taper--but I think what they've said is that they don't want rates to rise too quickly. If rates are rising too quickly, they're going to slow the taper down. The market had it wrong, so to speak, by thinking that the taper meant higher rates.

Benz: We had that big shudder in the market back in the May-June period.

Volpert: Yes. And I think now as the Fed starts tapering, if the market reacts badly--certainly they're going to talk a lot more about forward guidance and about "low for long"--but as they start tapering, if the market overreacts to it, they're just going to slow the taper down. I think, they also want to see how the rising rates that we've had, 100 basis points or more, what effect it is going to have on the economy. Of course, this whole Washington [impasse] is going to potentially slow the economy down and create more uncertainties, and the Fed wants to see how that plays out.

I would expect that they would hold off on doing anything on the taper toward the end of the year or maybe even into early next year, which is a good thing for rates and a good thing for the economy at this point.

Benz: Longer term, I know you must talk to a lot of investors who say that bonds are likely to have pretty meager returns in the next decade or so. People are saying, "Why do I need this asset class in my portfolio that's going to have maybe modest returns, maybe even losses over the next decade?" What's your counsel to investors who are aiming to figure out how bonds fit into their portfolio and whether they even need them at all?

Volpert: Bonds do provide a diversifier, especially if you are in the intermediate part of the market, a diversifier against stocks during periods when stocks drop a lot. And they do give you some additional incremental return. Now we had a situation when the quantitative easing was happening where real interest rates had gotten negative, which means you didn't earn inflation, which means you are losing real purchasing power. But with the recent rise in rates, 10-year Treasuries have actually moved back into a positive-yield environment, plus you earn a credit spread if you're in the corporate markets or diversified credit portfolio.

It's a better situation now where you are earning positive real return and not in this financial-repression kind of environment that we're in. And what that allows is that if there is a big sell-off in stocks, we could get real yields moving down to zero or to negative again, which should be a cushion and a diversifier with stocks. Also, a big part of the diversification benefit of bonds is, when stocks make a big move, it allows you to rebalance if [you have an all-stock portfolio] or you don't have that bond exposure or you don't really have the dry powder, if you will, to kind of reinvest into the underperforming asset class. So it's definitely an important part of a portfolio.

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