(PUB) Investing 2015

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Fund Family Shareholder Association

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projects of all shapes and sizes. For

example, they may need to repair roads,

expand a sewage plant or build a new

school. To raise money, these “municipal-

ities” issue bonds called municipal bonds.

Municipal bonds come in different

flavors based on how the money owed

on their bonds will be paid back. Some

muni bonds, called general obligation

(GO) bonds, are backed by the taxing

power of the state or city—some por-

tion of sales and property taxes are used

to pay bond holders. Other muni bonds,

called revenue bonds, are backed by

user fees. For instance, tolls collect-

ed on highways, revenue collected for

water or sewer services, or even fees at

the town swimming pool may be used to

pay off the debt incurred to build those

facilities in the first place.

But what really sets municipal bonds

apart from Treasury, corporate and

mortgage-backed bonds is taxes. The

income generated by muni bonds is not

taxed by the federal government. And if

you buy a municipal bond issued by the

state where you live, that income is not

taxed at the state level, either. Hence,

municipal bonds are also called “tax-

exempt” or “tax-free” bonds.

Given the vast number of states,

counties, cities and towns in the U.S.,

it’s not surprising that the municipal

bond market is very fragmented, with

over 47,000 different bonds available,

compared to, say, the 9,500 or so found

in the Barclays U.S. Aggregate Bond

Index (the index mimicked by

Total

Bond Market

Tax-Exempt Bond

Index

, Vanguard’s first muni-bond

index fund, tracks an index of more

than 10,000 very high-quality bonds

alone. As you might expect, there are

many, many types of municipal bonds,

so my description, while not compre-

hensive, covers the majority of plain-

vanilla municipal bonds and certainly

covers the vast majority of bonds held

in Vanguard’s tax-exempt bond funds.

To BuyTax-Exempt Bonds or Not?

Tax-free income sounds great, so

why would you want to own any bonds

other than munis?

First, if you are investing in a tax-

deferred account, like an IRA, income

from a municipal bond fund is treated

the same as income from a corporate

bond or Treasury fund, and you may

actually do yourself a disservice by

investing in a municipal bond fund here.

Why? Because when you finally begin

taking distributions from a traditional

IRA, you will be taxed on income that,

normally, would not be taxed. That

makes no sense at all.

Plus, historically, tax-exempt bond

funds have yielded less than Treasury

bond funds with similar maturities, and

without the tax-exempt advantage, you

wouldn’t buy the lower yield.

However, since the beginning of the

financial crisis in 2007,

Intermediate-

Term Tax-Exempt

has regularly

yielded more than

Intermediate-Term

Treasury

, even before adjusting for

taxes, so you could make an argument

for owning municipal bond funds in

your tax-exempt account today. But

don’t expect this reversal of historical

trends to last. Personally, I’d rather own

one of Vanguard’s corporate-oriented

FOCUS

FROM PAGE 1

INTERVIEW

DONALD KILBRIDE

Committed Concentration

DIVIDEND GROWTH

HAS LONG BEEN A FAVORITE

since Don Kilbride, 49, a value manager at Wellington

Management, took the fund over and built a concen-

trated portfolio of battleship balance-sheet companies.

The fund has served us well in the

Model Portfolios

since I first added it in November 2007. It has served

Don well, too, as he is invested alongside you, me and the fund’s other

shareholders. Don, Jeff and I recently spoke about the portfolio, the state

of the world’s markets, oil and what works in investing. Listen in…

How is your strategy of looking for growing streams of dividends

playing out in the current low interest-rate and slow-growth

economic environment?

The same, at least among the companies we own and the ones that

we are interested in. That’s not an extensively long list of companies.

We have a narrow universe. There is certainly a powerful ability

among the companies that we are looking at, and the willingness is

still pretty strong. Right now, balance sheets are extremely strong

across the fund with almost no exceptions. Checking the balance sheet

is part of my formula, as that is what leads to a strong ability to grow

dividends.

Previously, you’ve expressed concern around central bank activ-

ity. Are you still cautious today? And if so, what would make you

more optimistic?

You are exactly right; I’ve been cautious in large part because of the

amount of liquidity in the system by virtue of what the central banks are

doing globally. It’s not just a U.S. phenomenon; it’s the ECB; it’s the Bank

of Japan, China—there’s just lots of [liquidity] in the system. My concern

is that that is what is propping up markets right now—or at least is

in some way helping to prop up markets. I am worried about how we

reverse that. At some point, the central bank liquidity has to come out

of the market, and it has to be replaced. So what would make me more

optimistic, frankly, is if we got back toward an environment that is more

normal. I think we are slowly crawling that way.

But what does “staying cautious” mean in terms of constructing

the Dividend Growth portfolio?

It means we have slightly more names than you might normally

expect. Again, this is a highly concentrated portfolio—and I think that’s

the right thing to do. So we normally run somewhere in the mid-40s,

and we might have a couple of extra names there. Just on the margin,

that’s a little more cautious, and spreads the position sizes out a little

bit more. Maybe run [the portfolio] with a little bit more cash. Not to

buffer any downside, but to be in a position to be more opportunistic if