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Bond selection: Giving credit where it's due

July 02, 2014

Bonds, loans, and credit cards are part of our everyday lives, and they have more in common than you might think.

A bond is basically just a loan you make to an entity such as a private corporation, school district, or government agency. They vary in term, from just a few months through decades, just as a fixed-term loan like a mortgage or auto loan does. They can be secured, as with that auto loan or mortgage, or unsecured, as with your credit card.

Jean LuFor the managers who oversee Vanguard fixed income funds, there's no shortage of bonds to choose from. When deciding whether to include a bond in one of our funds, we assess some of the same things a mortgage lender looks at when reviewing an application—credit quality chief among them.

The goal in both cases is to get a good return on the investment without taking on undue risk. That's where our credit analysts come in, applying their extensive expertise about bond credit quality to identify securities that find that balance.

"Vanguard's investing philosophy and focus on low cost helps us manage our funds in a very risk-controlled manner," said Jean Lu, a credit analyst with Vanguard Fixed Income Group who specializes in municipal bonds. "We don't have to reach for speculative investments to offset higher costs."

Diving into due diligence

A credit review is the first screen through which a bond must pass before making it into a fund portfolio. Analysts research reams of publicly available disclosure on each bond issue to form independent judgments and assign internal ratings. And there are a lot of bonds to investigate; according to the Securities and Financial Markets Association (SIFMA), about half a trillion dollars—$467.4 billion to be exact—in new bonds have been issued this year (as of April 30, 2014).

"Vanguard's investing philosophy and focus on low costs helps us manage our funds in a very risk-controlled manner. We don't have to reach for speculative investments to offset higher costs."

– Jean Lu

"We begin by scrutinizing the bond offerings and evaluating the likelihood that the interest and principal will be paid on time and in full," Ms. Lu said.

"Default risk, even with all the headlines, is a bigger consideration for our colleagues on the corporate side than for us on the municipal side, where defaults tend to be significantly lower. My job is more about finding relative value. I assign an internal Vanguard rating to every bond in my portfolio and work with traders and portfolio managers to determine whether the price at which it will be bought or sold makes sense, given the credit fundamentals."

Before considering the credit ratings independent third-party agencies such as Moody's or Standard & Poor's place on bond issues, "we want to come to our own rating decisions first," she added.

"When we're developing internal credit ratings, we look at quantitative factors that you can measure, things like an issuer's assets and liabilities, its cash flow, and revenues. We also look at qualitative factors, such as the quality of leaders at the issuer, what types of regulatory challenges might apply, even the political environment. Our approach differs from the rating agencies, which generally use standardized models that have recently focused more on quantitative elements. That's because of the regulatory scrutiny rating agencies undergo, as well as a desire to calibrate their ratings across different markets."

If our analysis uncovers concerns about a bond issuer's creditworthiness, an analyst may even conduct a site visit to inspect conditions. For example, Ms. Lu has personally toured waste-to-energy plants, nuclear power stations, and even the Jefferson County, Alabama, sewer system when it was going through its Chapter 9 bankruptcy restructuring process.

"Let's put it this way; issuers generally don't want me or one of my colleagues to make a site visit," she said, "When we come knocking, there's likely a concern we want to investigate."

A central part of the decision-making team

Credit analysts work closely with the traders and portfolio managers on their "satellite" teams to develop bigger-picture strategies that apply across portfolios. Each team, led jointly by a credit analyst and a portfolio manager, focuses on a segment of the bond market and follows the direction of the "hub" of senior leaders that determines overall vision and strategy, including Joe Davis, Vanguard's chief economist, Greg Davis, our head of fixed income investing, and the heads of each bond group.

"[Bond] issuers generally don't want me or one of my colleagues to make a site visit. When we come knocking, there's likely a concern we want to investigate."

Some interaction is formalized through regular meetings where the team brainstorms investment ideas and discusses the portfolios they oversee. There's also a great deal of informal interaction among team members as they discuss specific bond issues and strategize selections for individual funds.

"We're all looking to identify a bond's value, which lies at the intersection between the bond's creditworthiness represented by rating and its trading price," Ms. Lu said. "For example, if a bond is overpriced for its rating, there's no investment value even if the rating is AAA (the highest possible)."

This collaboration helps the team implement its investment recommendations more consistently across funds. It also allows us to measure how well each team achieves goals, including containing risk and putting best investment ideas into practice.

Members of each satellite team also share their knowledge and expertise with other teams. Ms. Lu works with colleagues on the corporate side, particularly in industries such as banking, insurance, energy, and aviation. "Collaboration across satellite teams and with the hub gives us the best of both worlds, allowing us to combine top-down and bottom-up management approaches. It also lets us leverage expertise for various disciplines," Ms. Lu said.


  • All investing is subject to risk, including the possible loss of the money you invest.
  • Diversification does not ensure a profit or protect against a loss in a declining market.
  • Bond funds are subject to interest rate risk, which is the chance bond prices overall will decline because of rising interest rates, and credit risk, which is the chance a bond issuer will fail to pay interest and principal in a timely manner or that negative perceptions of the issuer's ability to make such payments will cause the price of that bond to decline.
  • Although the income from a municipal bond fund is exempt from federal tax, you may owe taxes on any capital gains realized through the fund's trading or through your own redemption of shares. For some investors, a portion of the fund's income may be subject to state and local taxes, as well as to the federal Alternative Minimum Tax.
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