(PUB) Vanguard Advisor

YIELDS A No-Calorie Spread

HERE’S A THREE-YEAR anniversary that neither shareholders nor the folks at Vanguard are going to be celebrat- ing: The lack of any difference in yields between Tax-Exempt Money Market and Prime Money Market . After bouncing around for months and months, it was about three years ago that both money funds’ yields settled into a pattern of mimicking one another to the point that the “spread” between their yields began to hover around zero. As the chart to the right shows, it’s been that way ever since, with only the occa- sional short-term deviation. Of course, taxable investors in the muni money fund do enjoy a small advantage, as their yields are tax exempt, but when you’re earning just 0.01%, even a tax exemption doesn’t count for much.

part of 2015 at the earliest, unless the economy begins to fire on all of its cylinders. For now though, hold the confetti, forget about celebrating this dubious anniversary, and instead consider using a fund like Short-Term Investment- Grade as a cash substitute. Yes, you’ll be taking on more interest-rate risk, as the fund’s duration, a measure of that risk, is 2.4 years. But you will be taking home a 1.46% yield. Another alternative with an even shorter duration (1.0 years), and hence, less interest-rate risk, is Short-Term Tax-Exempt , which yields 0.30%. You still grab a respectable pop in yields with very little credit risk. It won’t make you rich, but it may assuage your pain while we wait for the next chapter in this epic interest-rate story. n

Prime/Tax-Exempt MoneyMarket Spread

-0.4% -0.2% 0.0% 0.2% 0.4% 0.6% 0.8% 1.0% 1.2% 1.4%

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When will rates rise? They’ll rise when the Federal Reserve begins rais- ing the fed funds rate or enacts other policies that, in effect, hike short-term interest rates. Unfortunately for sav- ers, this may not happen until the latter

If investors want to overweight corporate bonds or any other sector of the market, they have the ability to do that through adding a corporate index into the mix. But that’s not a reflection of what the market is. That’s an active choice that you want to be overweight to a specific sector of the market. Right. Cap-weighting is one definition of what the market is, but are investors unaware that the benchmark has become more interest-rate sensitive because the allocation to the most inter- est-rate sensitive securities has grown in these funds? If you look back, the weighting of corporates really hasn’t changed that much over the last decade. The index is slightly more interest-rate sensitive, yes, because rates are relatively low, so the duration of the index has extended a bit. [Duration on Total Bond Market, at 5.6 years, is significantly higher than the 4.0 year duration seen five years ago. —DPW] Corporates are currently 23.2% of the Barclays Aggregate, and the 10-year average has been 19.8%. It’s a source of diversification in a portfolio. The key thing to think about is what you are protecting yourself against—it’s the unexpected change in inflation. Where TIPS or an inflation-protected securities fund would outperform is if inflation comes in markedly higher than what’s being priced into the market. So, short-term, you have diversification benefits, and you also have protection if inflation comes in higher than what’s currently being priced into the market place. But if inflation is lower, TIPS would underperform relative to nominal Switching gears for a moment, how would you use inflation bonds in a portfolio? Are there better or worse times to be buying them?

bonds. If you look at it from a total portfolio construction standpoint it is a bit of a diversifier. The way I would look at it is in a market-cap weight- ing. The U.S. aggregated market has a market value of $17 trillion and TIPS represent about $902 billion. So you’re talking about 5%. Who would you recommend TIPS to? It’s folks who would be hurt the most in terms of a surprise pickup in inflation—those on a fixed income or close to retirement and whose earnings stream is no longer going to be inflation-adjusted. Some of our target-date funds start adding, as you get closer to retirement, a short-dated TIPS allocation into the mix to help guard against these unex- pected changes in inflation. As long as it’s not hyper-inflation, the equity market should be a bit of an inflation hedge as well. Why use the short-term inflation fund versus the longer-term fund? The long inflation fund has a very long duration. The short duration fund tends to be more responsive to unexpected changes in inflation, which is what you are trying to guard against. So who would use the longer fund? It’s basically a total fund, so it represents the total market. Again, if you are looking for broad diversification, that’s a good place to start. If you are concerned about protecting against unexpected changes in infla- tion without taking on a lot of interest-rate risk, you probably would skew closer to the shorter one because you don’t want to take on all that long- dated interest-rate risk associated with the broad TIPS market.

Many thanks, Greg.

The Independent Adviser for Vanguard Investors • July 2014 • 7

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