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Volpert: Shorter May Not Be Better When Rates Rise

Miriam Sjoblom, CFA

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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Sjoblom: And this is not the first time we've seen such a scenario, right?

Volpert: No. Actually, from 2003 to 2005, we had a very similar situation where the yield curve was very steep and it flattened out between those two years, between December of '03 and December of '05. Basically, in every recession over the last 20 or 30 years, we've encountered that same kind of experience.

Sjoblom: The market is expecting one thing, but the market is often wrong about what it anticipates. What are some other possible scenarios that bond investors should be prepared for?

Volpert: I think bond investors should be prepared for... One of the things that's going on with the euro is whether or not the euro is even able to stay together, and how that actually will play into the risk in the markets themselves, in the bond-market share in the U.S. If the euro problems create a banking crisis in Europe, that could create some problems in the U.S. as well.

We don't think that's the base case. Our expectation is that our recovery is a sustainable recovery, and that we're going to be fine. The recovery may get pushed out a little bit further by this problem in Europe, but not enough to really cause us to go into a double-dip or into another recession.

So, we actually think that this is a pretty attractive time to actually still be in the bonds because the Fed is going to stay on-hold for longer and that probably means that the money that's moving out of money market funds into bond funds will continue for a longer period of time.

Sjoblom: I should have mentioned that you're also the longtime manager of the Vanguard Total Bond Market Index Fund. Say at the end of 2008, investors in that fund were very happy to see that the index that tracks the Barclays Capital Aggregate actually held up quite well compared to a lot of actively run bond portfolios.

But, at the end of 2009, you heard a lot of talk of the index will likely underperform. Areas like corporates look very cheap. The Treasuries look very overvalued.

But fast-forward to today. You have seen the Total Bond Market Index Fund underperform a lot of actively run strategies, but how do things stand today?

Volpert: Yeah, I think what you brought out is a great point. When there's a big difference between how governments perform and corporates perform, the Agg Index, or total bond market, is going to look really good or really bad.

If corporates do much worse than governments, the aggregate fund is going to look really good. If corporates do much better than governments, the aggregate fund's going to look really bad. But when both are fairly priced, on a forward-looking basis, the Agg is probably going to look pretty good, very competitive.

That's where we are right now. So we've had this cycle of a big spike up in corporate yield spreads and a big spike back down, but now corporates are pretty close to their longer-term average.

So, looking forward, we think that an Agg fund, or a total bond market portfolio, is actually going to perform pretty well against the peers because it's giving you the average spread, but it's got a very low cost. It has much lower expense ratio than the average fund out there.

It has a lot less friction cost, transactions cost, because it's not actively trading bonds in the portfolio to try to add value. It's really just buying the exposure of the market at the lowest possible cost.

We think, looking forward, given where spreads are now, that that actually will be a pretty attractive place.

Sjoblom: I think it's a good reminder to investors to not just look at the extreme years we've seen, 2009 and 2008, and think about the long-term advantages.

Volpert: Yes. Absolutely.

Sjoblom: Thanks for joining us, Ken.

Volpert: You're very welcome.