The Independent Adviser for Vanguard Investors
•
July 2014
•
7
FOR CUSTOMER SERVICE, PLEASE CALL
800-211-7641
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%.
Switching gears for a moment, how would you use inflation bonds
in a portfolio? Are there better or worse times to be buying them?
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
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.
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.
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
YIELDS
A No-Calorie Spread
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
12/08
6/09
12/09
6/10
12/10
6/11
12/11
6/12
12/12
6/13
12/13
6/14
-0.4%
-0.2%
0.0%
0.2%
0.4%
0.6%
0.8%
1.0%
1.2%
1.4%
