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Investing Specialists

What, Vanguard Worry About a Bond Bubble?

In an uncertain world, the fund family remains sanguine about a diversified bond portfolio's prospects.

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Bond funds are climbing a wall of worry, but Vanguard contends that diversified, long-term investors may not have much to worry about.

A thicket of red flags flies over fixed-income funds--strong trailing returns, hot inflows, and suspect valuations in some bond sectors--yet they've continued to best other broad asset classes and attract investor dollars. Taxable-bond funds are beating both domestic- and international-stock funds so far this year, rising nearly 6% versus about 3% for U.S.-equity funds and less than 1% for foreign-stock funds. The performance edge, which extends over the three-, five-, and 10-year trailing periods, has attracted money. For the year to date through the end of June, taxable-bond funds have taken in nearly $120 billion, compared with $16.5 billion in outflows for domestic-stock funds.

The performance and flows persist even though the broad bond market's historically low yields implies skimpy returns at best. ( Vanguard Total Bond Market (VBMFX) yields less than 3%.) Gluttonous developed-markets government debt also presages inflation and interest-rate hikes at some point down the road, and both are anathema to fixed-income investors. Bonds will disappoint those expecting a repeat of the past decade. Even Bill Gross, manager of the giant  PIMCO Total Return (PTTRX), has said that bonds' best days may be in the past. That's why some argue investors have to get more tactical to eke out some kind of income and total return. They either have to take more interest-rate risk in the bonds of more fiscally prudent countries or assume more credit risk on individual issues or consider high-yielding stocks, such as drugmaker  Eli Lilly (LLY), which has a more than 5% yield, but also some company-specific and equity-market risk.

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Dan Culloton has a position in the following securities mentioned above: PTTRX. Find out about Morningstar’s editorial policies.