Volpert: Less Risk in Intermediate-Term Bonds Than Perceived

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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Benz: One thing we've seen when we look at where flows have been going, we've been seeing a lot of flows into some of the more credit-sensitive category, so if not high-yield, then certainly bank loans and some of the new so-called non-traditional-bond fund types? What's your take on investors' seeming preference there, where they are buying those types of funds and maybe shunning some of the more core-type fixed income instruments?

Volpert: We've seen a lot of flows into the shorter-term bond funds as well as you're talking about, either money market funds or short-term corporate bond funds, short-term index funds, et cetera. I think part of that is driven by the fear of rising rates. But I think investors need to realize, rates have risen a lot already, and the yield curve is pretty steep, which implies that short-term rates are going to up in the future.

So if short-term rates go up in the future, intermediate-term rates may not change at all because that's kind of what intermediate-term rates are already pricing in by having a positive slope yield curve. I think it's important for investors to realize that there's a lot less risk in intermediate-term bonds than investors might perceive right now given that rates have risen already so much and the yield curve is as steep as it is.

Benz: One category where I've heard a lot of concern from investors is in inflation-protected bonds. Vanguard recently launched a short-term inflation-protected bond exchange-traded fund. But let's talk about how investors should be viewing the TIPS asset class given pretty muted inflation currently as well as how TIPS might behave in a sustained period of rising rates.

Volpert: Yes, we came out with this fund, the Vanguard 0-5 Year short-term TIPS fund, ticker VTIP, about a year ago, and there's been a lot of cash flow coming into that fund and coming out of the longer-term fund. What's actually happened is, rates have risen. The TIPS market as a whole has a duration [a measure of interest-rate sensitivity] of almost 9 years, whereas the Treasury market has a duration of about 5 years.

TIPS have much, much, much longer duration and much more interest-rate risk. So if rates rise 100 basis points, the TIPS fund is going to way underperform a nominal bond index fund or bond market fund, and that's what has happened. So investors are seeing those negative returns and they're saying, "Oh my gosh. There's a lot of risk in here." I think we've been trying to tell investors there's a lot real duration risk in a TIPS fund.

When we did some research and came out with a research paper about a year and half ago, two years ago, what it revealed is, actually, if you want to hedge inflation, short-term TIPS has a much better correlation with inflation than intermediate-term TIPS or long-term TIPS do. So that's why we've created this short-term TIPS index fund, and we've reallocated all of our TIPS in our target-date funds out of the standard TIPS fund and into the short-term TIPS fund because we think it really accomplishes what most investors who are looking for inflation protection and are desiring out of the fund is really something that correlates more closely with inflation risk.

Benz: Who would use the old, sort of, intermediate- to long-term TIPS product and in what role?

Volpert: The investor who would use that is an investor who is looking for exposure to intermediate-term real interest rates. That is not so much you're looking for inflation protection as much as you think real interest rates are too high, and you want to have exposure to those high real interest rates for the longer term. But for really having some inflation protection, having returns that are pretty closely matched to inflation or are more closely matched to actually what happens to inflation, a short-term TIPS fund is a better alternative, we think.

Benz: Another new product that Vanguard launched and you don't do a whole lot of them, but recently, you came out with a hedged international-bond fund. I'd like to talk about what role such a fund might serve in a portfolio, and why did you choose to opt for a hedged product versus one that fully reflects currency changes versus the dollar?

Volpert: We did some research also on international bonds and the role of international bonds in a portfolio. What we discovered is, currency volatility is as volatile as equity volatility, and it doesn't have an expected return because currencies could go up or down. As we looked at the research, it showed that unhedged bond funds actually add risk, but don't add expected return. Now if you make a call and…

Benz: And you get it right...

Volpert: ...andyou get it right, you're fine. If you get it wrong, you're sunk. But on average, having that currency exposure has zero expected return. So when we look at the global aggregate bond index, or the full investment-grade market, taking out the U.S. dollar bonds, how does that correlate with a U.S. bond portfolio, like a total bond index? It actually was a very good diversifier. It actually helped reduce volatility and had about the same expected return as a total bond index.

So we came out with this fund, VWOB, which is our total international bond fund, and we put 20% of our target-date fund allocation into it. It started with about $14 billion in the portfolio from the very start, and we're able to diversify it across more than 1,500 securities. It's been a very good way to get the fund started, get it started with great diversification, and it's actually been helpful. It's actually outperformed the total bond index by a little bit.

You'd expect the volatility of these two funds would be pretty close to the same, but the drivers of the return on the total international fund are going to be what's happening primarily in Europe in terms of the yield curve and the dynamics of what's going on in their economy, and Japan and the United Kingdom. Those are the primary components. And they are not in sync. So that's good. That's what creates this diversification value, but they have the same longer-term expected return.

We think it's a good core investment for investors to combine with something like a total bond market portfolio.

Benz: You mentioned total bond market, and I know you probably have been getting a lot of questions about the composition of [Vanguard Total Bond Market Index] and the fact that it is heavily tilted toward a lot of government-issued or government-backed securities. I know some investors have questioned if this really is what they want for their core exposure. How do you answer that question? And has Vanguard considered maybe a product that is more actively managed as an alternative offering in the core fixed-income space?

Volpert: Yes. If you look historically, the percent in credit and in government is not that far out of whack compared with what it's been over the longer run. In fact, the float-adjusted index, which is what we manage this fund off, takes any of the Fed purchases of Treasuries and mortgage securities out of the index. So the float-adjusted index or Total Bond Market actually has less in government bonds than the non-float-adjusted index has because it's taking out those mortgage securities.

If you look at that, it actually is not that far different from the norm over the longer period of time. Corporates actually have been growing a lot. There's been a lot of issuance in the corporate bond market. So the corporate component actually continues to grow. We think it still represents the investment universe of investment-grade bonds, and we think for a core bond index investment, what's important is that it represents the universe. We think that's where you're going to be able to get the benefit that over the longer term, it's going to be difficult for active managers to outperform the universe of bonds within which they are investing.

Benz: Is part of the consideration the cost, as well, that might be associated with some sort of an active bond product because I know Vanguard has plenty of active equity funds?

Volpert: Well, we have a lot of active bond funds, too. I mean, we have short-term investment-grade, medium-term investment-grade, long-term investment-grade, Ginnie Mae, funds et cetera, some Treasury funds, TIPS funds. We have a lot of actively managed products. We don't have an active total-return fund, but we do have a lot of active products in various sectors of the market that we think are very good products and still benefit from Vanguard's ownership by the funds. So low-cost is a big part of it. And then we try to add incrementally above it. There are some very popular funds in that space.

Benz: Ken, always great to hear from you. I know this asset class has been top-of-mind for a lot of our readers and viewers. So, thank you so much for sharing your insights.

Volpert: You are very welcome, Christine. Thank you.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.