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Sauter: Credit Spreads Should Tighten

Dan Culloton

Dan Culloton: Hi. I am Dan Culloton, associate director of fund analysis at Morningstar, and I'm here today with Gus Sauter, chief investment officer of Vanguard.

Gus, thanks for being here with us today.

Gus Sauter: Thank you, Dan.

Culloton: Gus, among the many hats you wear at Vanguard is being head of the investment policy committee for a relatively new set of funds called the Managed Payout funds, which run like mini endowments for investors.

And in those funds you recently made a larger allocation to the Vanguard investment grade corporate fund, a more corporate-oriented fund in the funds' allocations. And I'm wondering if you could talk about what that says about your investment policy committee's, and your capital markets models', expectations for bond returns going forward?

Sauter: Right. Those funds are designed primarily for investors that are in the distribution phase of life. They are typically retired and drawing down out of the funds. So, we're trying to produce very consistent returns, more like an absolute return, which is a very difficult thing in the investment market.

We have investment committee that's charged with running those funds, and really we stick primarily with a long-term benchmark portfolio or policy portfolio, if you will. We do have a market model, capital markets model, that gives us suggested changes to that allocation, and we primarily stick with the policy portfolio, but, we'll certainly consider what the capital markets model is telling us.

So, specifically earlier this year, we did make an adjustment to one of the holdings and migrated some money from out Total Bond Market portfolio, bond index fund, into a credit portfolio. The model was telling us that credit was very attractive at that point in time and certainly, the spreads were extraordinarily wide. We felt it was an additional return for investors without really adding incremental risk to them. So, that was somewhat of an opportunistic thing that our modeling was pointing out and that's why that change was made.

Culloton: Would you say that those conditions still persist to an extent, even though spreads have come in a bit since?

Sauter: Yeah. We still have a bit of an overweight to credit. We're still positive on credit. As the economy strengthens we think next year credit spreads should continue to tighten a little bit further. So, we still have a bit of a slight overweight to credit.

Culloton: Once again, this doesn't mean that Vanguard has taken position that you should not have a diversified bond portfolio at all?

Sauter: No, by no means. No, we still certainly have exposure to Total Bond Market, and all we were doing was basically underweighting the Treasury segment of that a little bit in favor of corporates. Everything we do we believe strongly in diversification.

Culloton: Within those funds you also increased the REIT and commodity allocations of those funds; these funds can invest in those asset classes. What does that say about your expectations for those returns going forward? Should investors read anything more into those moves?

Sauter: Well, we've basically increased the weight back up to the policy portfolio. Our capital markets model had been signaling that it wanted to lighten up on both of those, both commodities and REITs, and we had lightened. Typically, the capital markets model will take us a bit further away from the policy portfolio then we would feel comfortable with. So, we're really not going to chase all over the place following the capital markets model, but if it wants an extreme underweight in something, we might underweight it by a little bit. And more recently the capital markets model has been moving back towards the policy portfolio, so we'd basically move those positions back to the policy position.