(PUB) Investing 2015

The Independent Adviser for Vanguard Investors

•

August 2015

•

FOR CUSTOMER SERVICE, PLEASE CALL

800-211-7641

fund), you are really picking between

price stability and income stability.

As a side note, every year in the

annual

Independent Guide to Vanguard

Funds

, you can find the two components

of a bond fund’s total return—its income

return and its capital return—in the

Details table on each fund’s profile page.

Safety orYield

But investing in bonds and bond

funds isn’t all interest rates and maturi-

ties. Not only do you need to decide how

long you want to lend money for, but

you also need to decide who you want to

lend that money to. Many different types

of entities need to borrow money, and

not every one of them is equally likely to

be able to meet their obligations to both

continue paying their promised inter-

est and pay you back your principal. In

bond lingo, the risk that the bond issuer

may be unable to pay back the money it

borrowed is called either

credit risk

default risk

Bonds issued by the U.S. Treasury

are often referred to as “risk-free”

because investors see the U.S. govern-

ment’s default risk as minimal to non-

existent. The government can always

raise taxes or print money to cover its

obligations. Of course, Treasury securi-

ties are still subject to interest-rate risk,

so they really aren’t risk-free unless

you hold them to maturity.

Bonds issued by corporations gener-

ally carry a higher risk of default. When

lending to an entity with greater default

risk, lenders (the folks like us who are

buying the bonds) want to be compen-

sated for this risk, usually in the form of

a higher yield.

If you are buying a bond fund,

default is generally not a concern, as the

funds are diversified to the point that

one company defaulting won’t derail

overall performance—this is especially

true at Vanguard, where funds often

hold more than one thousand indi-

vidual bonds. However, even ignoring

default risk, there are still trade-offs

to consider when deciding between

the safety of Treasury bonds and the

higher yield of a corporate bond-ori-

ented fund, like

Intermediate-Term

Investment-Grade

Bonds issued by companies with

greater credit or default risk tend to be

more sensitive to the economy than to

changes in interest rates. Why is that?

As a rising tide tends to lift all ships,

a growing economy makes it easier for

even less financially stable companies

to pay back their debts. But a faltering

economy can be enough to derail those

same companies and damage their abil-

ity to make bond payments. (This is

particularly true when we start talking

about high-yield bonds, or junk bonds,

which are rated below investment grade

and are the most likely to default.)

While corporate bonds are less sensi-

tive to changes in interest rates, being

tied to the economy means that they

are more apt to be buffeted by the same

factors that move stocks than Treasury

bonds are. Consider the charts above

showing the average returns of

Inter-

mediate-Term Treasury

, Intermediate-

Term Investment-Grade and

High-Yield

Corporate

in different environments.

The first chart shows the aver-

age return of each bond fund during

months when

500 Index

was either

positive or negative over the past 15

years. In months when 500 Index fell,

Intermediate-Term Treasury on average

gained 1.0%, which put it ahead of its

corporate-bond heavy siblings. High-

Yield Corporate actually lost 0.9% on

average in months when stocks were in

the red. Conversely, when stocks rose,

the corporate bond funds outpaced the

Treasury fund.

The second chart shows the average

returns for the three bond funds inmonths

when the yield on Intermediate-Term

Treasury rose or fell. All three funds did

better on average when yields were fall-

ing—no surprise there. Treasurys were

the most sensitive to changes in inter-

est rates, performing best when yields

fell and dropping when yields rose.

Compare that to High-Yield Corporate,

which delivered positive returns on aver-

age when rates were rising. This is partly

due to the higher yield of the junk bond

fund helping to offset the impact of fall-

ing prices, but keep in mind that rates

tend to rise when the economy is doing

well—a good environment for more

risky corporate issuers.

In sum, the charts describe the trade-

off between Treasury and corporate

bonds: Treasurys offer more down-

side protection when stocks fall, but

carry more interest-rate risk. Corporate

bonds don’t offer as much of a buffer

when stocks are falling, but are less

sensitive to swings in interest rates.

For my money, Intermediate-Term

Investment-Grade—with a portfolio

that is predominately invested in high-

quality investment grade-rated corpo-

rate bonds—has balanced the trade-offs

between interest rate and credit risk

well, and with its higher yield, should

continue to outperform Intermediate-

Term Treasury over the long run.

Inflation Risk

Another risk, hidden yet insidious,

inflation risk

, or the risk that a

bond’s return may not keep up with

inflation. As you know, inflation is a

broad increase in the prices of goods

and services. One outcome of inflation

is that your purchasing power decreas-

Protection From Falling

Stock Prices…

Int.-Term Treasury

Int.-Term Invest.-Gr.

High-Yield Corporate

-1.25%

-1.00%

-0.75%

-0.50%

-0.25%

0.00%

0.25%

0.50%

0.75%

1.00%

1.25%

1.50%

1.75%

Avg. Monthly Return When

500 Index is Down

Avg. Monthly Return When

500 Index is Up

…Versus Sensitivity

to Rates

Int.-Term Treasury

Int.-Term Invest.-Gr.

High-Yield Corporate

-0.75%

-0.50%

-0.25%

0.00%

0.25%

0.50%

0.75%

1.00%

1.25%

1.50%

1.75%

2.00%

Avg. Monthly Return When

Yields Fall

Avg. Monthly Return When

Yields Rise