Live webcast replay: A look at today's bond market
April 17, 2013
Replay and transcript from a recent Vanguard webcast
With interest rates set at historic lows by the Federal Reserve, investors have had to temper expectations for income from the bond portion of their portfolio. In this live webcast aired March 28, 2013, Ken Volpert of the Vanguard Fixed Income Group and Sarah Houston of Vanguard Flagship Services® discussed the role bonds still play to diversify an investment plan, and what we might expect from bonds down the road given the sparse income environment.
Amy Chain: Good afternoon, thanks for joining us for this live Vanguard webcast, whether you're viewing us through your computer, your tablet, or you smartphone. I'm Amy Chain and today we're talking about investing in today's bond market, and how the current low-yield environment might influence your portfolio.
Joining me today are two of Vanguard's leaders. Sarah Houston of Vanguard Flagship Services and Ken Volpert from our Fixed Income Group. Sarah and Ken, thanks for being here today.
Ken Volpert: Thanks, Amy.
Sarah Houston: Thanks.
Amy Chain: If you are a bond investor, you've probably enjoyed strong returns for several years now. But as we all know, seldom does the future replicate the past. A big part of what's driven strong bond performance has been an increase in bond prices, which has pushed yields to historical lows since, remember, bond yields and prices move in opposite directions.
Today bond investors are receiving slender yields with little opportunity for further price gains. Add to that the uncertainty about the effects of unprecedented action by the Federal Reserve to hold down interest rates, and bond investors are facing a much less hospitable climate than the one they've become accustomed to.
So we've asked Sarah and Ken to join us today to help you figure out how to navigate this current bond landscape. And, as always, we'll be taking your questions throughout the webcast. You can even tweet us your questions using #VGLive. Does that sound good?
Ken Volpert/Amy Chain: Sounds great.
Amy Chain: Good. We usually come right to you audience with our first question; we want to learn a little bit about you. Today's going to be no different. So, on your screen you should see our first polling question. And what we'd like to know is, "Which of the following best describes the role that bonds play in your portfolio?"
So while we wait for the audience to respond, Ken, I'd like to come to you and have you tell us a little bit about what's going on in the bond market today, the current landscape of the bond market, and maybe what might be ahead for us.
Ken Volpert: Sure, I'll be happy to, Amy. So we've been through just kind of going—try to get up maybe to 10,000 feet, and kind of look at where we've been over the last number of years. Leading into 2007, 2008 there was a lot of growth in the economy that was really driven by a lot of borrowing, a lot of excess borrowing. As you recall there was a lot of people taking equity out of their homes and consuming based on that. So there was a lot of leverage in the economy that led to some growth during those years, but ultimately it was too much leverage that was not really sustainable.
In 2008 with the problems that happened with some of the financial institutions led to a deleveraging cycle. Basically, an increase in savings by consumers, selling of assets by financial institutions, all of which kind of created the recession, a very deep recession that led to very large government deficits to keep the economy going. But also led to the Federal Reserve doing this quantitative easing program, which is basically where they've been buying up to now about $2 trillion of assets. What that's done is push down interest rates lower and lower, and actually has created some more, a little bit more inflation. And we've inflation about 2–2.25% over the last number of years.
So this financial repression is really what we're seeing right now, where we have interest rates that are below the inflation that we're realizing, and that's kind of what people are struggling with I think on the bond side.
I have a graph that maybe we can bring up right now, but it shows the historic yield to maturity, which is the yield that you get when you're investing in a bond to the life of the bond that includes not only the coupon but to the extent that it's bought below the price of par, or price of 100, you're going to get some return coming from that. If you pay above 100, you're actually going to lose some return, but it's netting those two together over the life of the bond to give you an estimate of what the yield is going to be.
What you see on the blue line is the yield to maturity historically, and if you look at the orange line you're going to see what the return is for the next 10 years. So what this graph is really communicating is that the yield to maturity right now is a really good estimate of what you're going to get over the next 10 years in this investment. It's really been a very reliable indicator. So it gives you a very good approximation of what the return is going to be.
Right now that yield, or as of December 31, that yield was 1.74% yield for the whole U.S. bond market, investment grade, which includes Treasuries, mortgages, investment-grade corporate bonds.
So investors looking forward should expect that that's the kind of return you're going to get: 1.7% to 1.8% return over the next 10 years. So that's maybe a good helpful framing, I think, of the discussion that we're going to have over the next hour.
Amy Chain: It is. Thanks, Ken. And I think we're probably going to be back talking about that again. I'm sure that's not the last time we'll be looking at that graphic either.
Ken Volpert: Right.
Amy Chain: So we do have our response in from our audience, and it looks like the lion's share of our viewers here today use bonds for diversification; about 78%, close to 80%, of our viewers are diversifying with bonds. Is this answer surprising? Were we expecting diversification? Did we think we'd have more income investors?
Sarah Houston: I think I probably expected we'd have a few more, but I'm delighted to hear that people are using them for diversification. I think that's a powerful way to use bonds.
Ken Volpert: Yes, I would agree, that's the primary. Most of the people probably have—a lot of them are still in the accumulation stage, so they're not really living off of the income, so they're really using it as a diversifier against their equity holdings. And I think that's great, that's a large percentage share showing that.
Amy Chain: Now one answer we could have given as an option for our audience might have been "chasing returns" or "because of performance." And I think that answer, maybe we were a little bit scared that we'd find out that some of our audience was actually doing that, which we wouldn't have wanted to hear. Maybe one of you could take us through why that might be a little scary for us to find that our investors were doing.
Ken Volpert: Well, it is a concern; you saw some of that in 2008 when the stock market sold off. Normally, if you're rebalancing to a mix of stocks and bonds, you should be buying stocks, but a lot of people were selling stocks and buying bonds, which is not really the type of thing that you would do if you had a disciplined investment process in place.
So we do get concerned if people are chasing past performance. And that's something that we as investors need to constantly be fighting against, against looking in the rearview mirror instead of looking forward in terms of what the returns are going to be on a forward-looking basis, which is really how investors should be investing. And so that means if prices have dropped and returns have been really bad on an asset class, that's an asset class you should be buying, not an asset class you should be selling.
Amy Chain: And the interest rate environment certainly has more of an impact—depending on where interest rates go—will have more of impact on those chasing returns than perhaps some that are investing for the income reasons or the diversification reasons. Is that right?
Ken Volpert: Right, that's exactly right.
Amy Chain: So audience you know the drill, we're back to you with a second polling question. We want to hear from you, "Have you reduced your bond allocation as a result of the current low-yield environment?" We'll give you a few moments to log in and, in the meantime, Sarah, maybe you could tell us a little bit about the roles that bonds or bond funds should be playing in an investor's portfolio.
Sarah Houston: I think a key to a sound investment strategy really is whether an individual creates that suitable asset allocation. So what is that mix of stocks, bonds, and cash that really works for their specific situations? So looking at their goals, looking at their risk tolerance, and looking at also what's their time horizon for investing and needing those funds as well.
And each asset class really does have a particular role to play in that portfolio. So stocks, they're predominately there for their growth potential beyond inflation. With that potential growth also comes some potential volatility. Bonds, as our viewers tend to know, they really are there to help moderate that volatility and help to mitigate some of the stock market risk and also to produce some income. And then cash is really there for the short-term spending needs or for preservation of capital. And then that diversification, in terms of the mix that you have, it's a really powerful strategy when it comes to managing the overall risk in that portfolio.
And if you think about it, it makes sense, and you kind of alluded to it, that the markets don't perform in tandem in terms of stock market, bond market. And by holding a mix across the different asset classes, what you really are enabling yourself to do is to participate in the strong performing ones but also mitigate the impact of the weaker ones to your overall portfolio.
Amy Chain: And we talk about having an allocation and sticking with it, so maybe you can tell us a little bit about when it might be appropriate to reconsider your allocation and when maybe not.
Sarah Houston: Yes, absolutely. I think a good rule of thumb to think about, when to come back and look at that strategic asset allocation that you've set for yourself, is to think about it in terms of significant life events. So when something may have really changed and you want to take another look at risk return characteristics, have things changed for you? So that could be a birth of a child; could be marriage; could be even a significant upcoming cash expenditure, maybe child's college tuition, buying a home, those type of things.
I think another time, which really kind of gets to the life stage as well, is someone who's approaching a planned retirement. And when someone is approaching a planned retirement and knows that there won't be a salary coming in, there are some investors that view that as an opportunity to really lower the volatility of their overall portfolio and—to do that—maybe increase bond allocation.
There's another time when we actually think it makes a lot of sense to readjust what your allocation is, and that's when it comes to—because markets perform differently, if over time say a bond allocation has risen or fallen and has drifted away from what that strategic asset allocation that you set was initially, then it makes sense to take a look and say, "do we need to rebalance?"—is essentially what we're talking about, to get back to the original risk and return characteristic that you were looking for.
Amy Chain: So it's checking your current allocation against your original game plan and making sure that the two are still in line.
Sarah Houston: Absolutely. And I think we've got a chart that does a nice job of really illustrating what some of the potential benefits of that can be. If you look at this chart what you actually see is, on the left-hand side you've got an investor who invested $100,000 at the beginning of 2008, which we know was a significant year in terms of there was a significant market sell-off for stocks, 60-40% split between stocks and bonds, so a balanced investor. What the middle chart actually shows is that after five years, at the end of 2012, if that investor had not rebalanced at all, what the mix of their portfolio would look like.
And it's actually not distressing, right? It's a fairly nice return, but contrast that with what you see on the far right-hand side. And what the right hand shows is really if that investor had been disciplined and actually rebalanced after that market sell-off, really as Ken mentioned before, enabling them to even participate more in the undervalued class at that point in time, they were in a better position at the end of 2012.
Amy Chain: That's fabulous. I think a lot of investors who are looking at that chart right now are probably finding it interesting. It's a concept that I know we walk a lot about here, but until you see it on paper and see how it plays out with the numbers, it's not always real, so that was a great concept to bring up.
Sarah Houston: And I think the other thing is that it's important so, yes, the additional return looks nice in this scenario that may not always play out. But, importantly, they really did get back to what the original risk profile looked like as well through the rebalancing.
Amy Chain: I got a sneak peek at some of the questions that came in from our audience ahead of time, and I know we have lots of questions on this topic, so we'll be back to you for more.
Sarah Houston: You did ask me another question though, and that's when it might not be a good time to sell off, right?
Amy Chain: I did, keep me honest, talk to us about it.
Sarah Houston: I think a good time—and a very hard time—is if you think that or if you're tempted to do something simply because of what you think may happen with the markets. Generally speaking we would suggest that is not a good time to actually make significant changes in that strategic asset allocation. That tends to be more like market-timing, and you know we've learned over time, and through our research know, that is a really difficult strategy to do successfully.
Amy Chain: Well, sage advice, and it translates well into the results of our second polling question, which are in. We asked our audience if they reduced their bond allocation as a result of the current low-yield environment, and it looks like, again, the lion's share of our—well I wouldn't call it the lion's share—we've got about 46% saying, "no, haven't made a change," which is great, that's just what we want to hear.
Yet we have about 35% that are saying they haven't done so yet but they're considering it. And so we've got investors sitting there with their hand on the mouse not sure if they should click. What do we think about that? Is this in line with maybe what you're hearing your clients talk about, Sarah?
Sarah Houston: Yes. I'm actually not surprised. I'm happy to hear that we have almost half who haven't made a change. But we actually do hear a lot of concern from clients right now. They're looking for input in terms of what to do because it is a challenging environment.
Amy Chain: Anything to add, Ken?
Ken Volpert: No. I think it's great to see that there's long-term, steady mix in terms of the investors actually staying with their mix and not reacting to the motions of what's going on in the marketplace. And I think, as Sarah was saying, it's really important that they have a good portion that's in fixed income—or a reasonable portion that it's in fixed income—so that when there is volatility in the market they can sell the better-performing asset and buy the underperforming asset to stay with that fixed mix.
Given how strong the equity market is, we wouldn't expect people to be selling bonds right now, right? We would expect they would actually be interested potentially in buying bonds, because their equities have been going up as a share because the equity market has been as strong as it has been.
So to see them actually not reducing their bond allocation means that they're not emotionally chasing performance of the equity market right now.
Amy Chain: That's what we want to hear, right?
Ken Volpert: Right.
Amy Chain: And certainly we have lots of resources available between commentary on our website—we're always a phone call away if anybody ever wants to talk through any of these questions. We've got lots of help available for you.
So I think we're going to turn it over to you, audience; I'm going to start looking for some questions to ask our panelists here. I have some on my screen already and I encourage you to keep sending them in throughout the afternoon. Does that sound good?
Ken Volpert: Sounds great.
Sarah Houston: Yes.
Amy Chain: Okay, so let's get started with a question from Terrance. Sarah I'm going to send this one your way. Terrance asks, "How can you continually say stick with your allocation when pretty much every article on the subject talks of bond prices dropping off a cliff when interest rates start to go up?" Well that is a very passionate question, Terrance, so we thank you for it. Sarah, talk to us a little bit about that.
Sarah Houston: I think Terrance asks a question that's on the mind of a lot of investors actually. And I think there are actually three pretty important aspects of it that I heard. The first is Vanguard's belief in asset allocation and how important that is to having a successful investment strategy.
Our firmly committed position to asset allocation is really based on research that's been done both at Vanguard as well as academic studies that very clearly illustrate the vast majority of the investment outcome of a portfolio is really determined as a result of what asset allocation decisions an investor made. In fact, it's almost 90% of the investment outcome, the risk and return characteristics really do come from what decision an individual made.
Amy Chain: So often people are reading the headlines, and watching the markets, and worried about what's going on in the environment, when the first question they might want to be asking is, "Do I have the right allocation; and have I rebalanced; and does my allocation match my investment goals, my time horizon?"
Sarah Houston: Right, absolutely. And that assumes that someone has gone through all of that as well in terms of really setting very concrete strategy based on what they've been able to articulate their goals are. And I think you really touch on the second part that I think is important to address, is that there is a lot of noise in the marketplace and that makes it very, very difficult to not act and to not do something, to be disciplined.
If you think about it, though, the reality is that there have been a lot of articles about the potential for interest rates rising for a long time now. I think back it was probably 2011 there were a lot of articles saying that 10-year Treasury yield at that point was 3%. Interest rates would have to rise. And so it hasn't happened, and I think that's just another good illustration that no one knows exactly what's going to happen in the market. So having that strategic asset allocation, really, we think it's the best course of action to have.
I think the third thing to keep in mind is that the impact should rates go up—to keep perspective of if interest rates go up. A bad year in the bond market doesn't necessarily look like a bad year in the stock market. And I know Ken's going to keep me honest on this, but stock market downturns you could see negative 20, 30, 40% returns. I think probably worst year from a bond market perspective has been negative, high-digit single returns.
Amy Chain: And this is where we get into the risks of investing in bonds are different than the risks of investing in stocks. Is that a fair statement?
Ken Volpert: Yes, absolutely. I think the stock market is owning the companies and they're actually come behind the bond holders in terms of a claim on assets. So that helps the bond holders actually have what's called a more senior or more secure position.
But I would just point out again realistic expectations for bond investors as well as stock investors going forward. So we looked at the yield to maturity of the bond market right now—about 1.7 to 1.8%—that's a reasonable number for what investors should expect out of investing in intermediate-term bonds, the total market over the next 10 years. And then on top of that you may get 3 or 4 or 5% in equities on top of that return, that "equity risk premium," as they call it.
So investors—you know we've come off a huge bull market in stocks and bonds over the last 20 or 30 years, and investors need to have realistic expectations going forward around what they can expect to earn in these markets.
I would bring that up as a point for people to remember as they look forward.
Amy Chain: That's important, thank you. Sarah, you talked about headlines and investors reacting and, Ken, I'm going to come to you with a related question, and that question comes from Linda in New Jersey. Linda asks, "Why is everyone warning us about bonds now when interest rates aren't projected to rise yet?"
Ken Volpert: We're getting further and further through this financial repression cycle or this deleveraging cycle. So usually these cycles last 7 to 10 years after a major deleveraging cycle—selling of assets, reducing the size of the banks, consumers increasing their savings, and the housing defaults that we've had, and all that's going on. So usually that lasts about 10 years until the balance sheets get righted, and get put back in order, and then consumption can pick up again.
Well we're about five years through this now, four and a half to five years. So we're getting closer to the end than we are to the beginning of this cycle. And what's going to happen there is we are going to move towards more normalized yields. Right now we have these financially repressed yields, where the yields are actually lower than inflation. When we get to normalized yields, actually, yields should be higher than inflation.
Inflation is running around 2 to 2.5%, so yields should be—the market yield should be maybe 1% higher than that, so that would put it around 3.5% from 1.7. So we do feel pretty comfortable that over the next number of years we should see rates rising to a more normalized yield environment.
The thing is, it's not something that we think is imminent, right? It's not going to happen in the next three or six months in our opinion, because the economy—the Fed still wants to see the economy growing before they start pulling back on the QE. They want to see some sustainability of this recovery. The government we know is cutting back on its spending, unemployment comp and all these kinds of things are actually fewer, and fewer people are needing that, so that means less government stimulus for that kind of initiative.
I think it's going to be a little while before we start really seeing a more significant rise in rates. And for investors who are sitting in cash, they're basically earning zero. At least the bond market has given you a couple of percent returns. So if it takes a few years before we get back to normal, you could be losing a few percent a year relative by sitting in cash.
So I think investors really need to gage how long it's going to take for us to get back to this more normalized yield environment, and if it looks like it's going to take a few years, they may want to stay in bonds for a little while longer.
Amy Chain: So we're talking about bonds, talking about interest rates. We have a Twitter question. Let's start with this one from Brandon. Brandon says, "Is the Bogle approach of investing your age in bonds still appropriate in this environment?" And he actually asks a second question, which is similar, and it says, "Even if bond returns are as poor as in your chart," we should say "bond expectations," "is there still value in diversification?" This gets back to the inverse relationship with stock prices, Brandon points out. What do we think?
Ken Volpert: I think if you look at the target date allocations, which are these single-funds that give you a sense for what the mix is between stocks and bonds, this is a good estimate of what Vanguard's view is around how much stocks and bonds you should have. The income kind of target date funds have about 30% stocks and 70% bonds.
And when you retire at 65, that may be when you're going into that kind of a fund, you still have 30 years ahead of you. It's not like you're going to die at 66 years old. You could live to 90 or 95, we don't know how long people are going to live who are retired right now.
So that long of a time frame you still want to have a good amount of stocks. And certainly if you're 10 years to retirement you want to have—I think the target date funds are more like 55% stocks. If you're 20 years to retirement it's more like 70% stocks.
So you can see the further you are away from—if you kind of work out, 30 years, 40 years, 50 years of life expectancy still left, you want to have a larger and larger allocation to equity so that you have the growth. Not just the growth in assets but also the expected growth in the income stream, because dividends grow over time, whereas fixed income investments don't have a normal increase in their dividend payments.
Sarah Houston: And one other thing I would just add just in terms of diversification in general, one of the things that it really does help to do is when you've got different exposure to all the different asset classes, it just helps to mute significant swings that occur because of the significant downturn. So when the question asks, "are bonds still good from a diversification standpoint in light of all that's going on?" they do provide a very powerful way to help moderate some volatility.
Ken Volpert: Absolutely.
Amy Chain: That's great, great addition. Let's go to a question from Dick in Washington. This is a good one, they're all good ones, but I like the last part of Dick's question here. "I've been told that bonds are overpriced and ready for a fall. But isn't the stock market also precariously high, making it a poor time to move into it?" Here's the best part, "When is Vanguard going to open a mattress fund?"
And I assume, Dick, that you mean a "fund to put your money under the mattress" type of fund. Who wants to take this one?
Ken Volpert: I think we all have those mattress funds right at our homes.
Amy Chain: That's true, low cost, right? You've already got it.
Ken Volpert: Yes, I think it's interesting because, when you look historically, if you take the earnings on the stock market divided by the average price of the stock—if you look at the S&P 500, for example, it's about a 6% yield right now (the earnings yield divided by the price—the earnings divided by the price of the S&P 500)—that's about what it has been historically since the end of World War II. Bonds on the other hand— the last 30 years bond yield has been about 6.7%. As I mentioned earlier that's about 1.8%. So, clearly, bond returns, or bonds' expected returns, are lower using that graph that we looked at earlier that really pointed out that the yield to maturity right now of the total bond market is the best estimate of the future return over the next 10 years.
Whereas stocks, they seem to be actually fairly priced, not rich or not cheap at this point. So I would say that it's very possible that stocks will provide a pretty good return and earn that risk premium, which is likely to be in the 4% historical risk premium that they've typically earned over the next 5 to 10 years and beyond. I don't know if you have any thoughts on that.
Sarah Houston: Yes, I think part of what you've talked about illustrates we don't know exactly what will happen, right? The viewers are going to get tired of hearing me talk about the importance of asset allocation, but I think that question is a really good example in terms of market-timing is probably not a great approach because it simply has not been successful for people. And coming up with what's that asset allocation and investing accordingly based on what your own goals are and risk tolerance. It serves you well.
Amy Chain: Speaking of mattresses, I'll tie this in for you, Dick. We talk often about, how do you know if your asset allocation is right? And a sort of high-level rule of thumb I've heard is, if you can sleep at night, if there's swings in your portfolio and you can sleep at night, your allocation may be appropriate. If you're losing sleep over volatility, you might have to rethink whether or not you're in a too-aggressive a portfolio or something like that. Is that a fair statement?
Sarah Houston: Yes, I think that's a great example. And for those people that don't yet know whether they'd be able to sleep at night, there's some really nice investor questionnaires and tools on our website and other websites to actually help people get an idea if they're looking at a particular asset allocation—what would have been the worst performing year, the best performing year—to give them some sense of would they be able to sleep with that kind of volatility.
Ken Volpert: Yes, I think an important thing for people to realize is—a lot of this is an education thing, and they need to understand how the markets work, when you own equity, what are you owning? You're actually owning a company that's growing and producing goods versus a loan, which is basically what the bond investor is owning. And that they really need to realize that if they're too conservative in their mix, they're most likely going to have a lower expected return over the long run. So there's going to be a cost to them in their savings, in their retirement, by being too conservative. And to really understand, and learn, and Vanguard's got a lot of stuff on our website that really addresses and tries to educate investors to really understand the nature of the equity market and the fixed income market, the importance of diversification, the importance of having an appropriate amount of risk for a long-term investor, so that you have enough assets for you when you retire rather than being short on assets because you were too conservative in how the money was being managed.
Amy Chain: Okay, thank you both. We have a live question that just came in; it's a little bit of a clarifying question. Ken, this one's going to come to you. The question is, "I've heard the phrase "realistic expectations" several times. Are you basically saying to lower my expectation substantially? Am I wrong?" I think that probably depends on what your expectations are, but take us through a little bit more about what that chart is really showing us.
Ken Volpert: Yes. Okay, let's go back to the chart again. I think it's uncanny how close those two lines are tracking or have tracked. And it's logical what it's saying, because when you're buying a yield, you're buying a yield on a fund that has six-, seven-, eight-year average maturity. So you'd expect to earn six- or seven-year—1.85% yield for six- or seven-year average maturity bond fund. So to expect over 10 years you should get pretty close to that yield. And that's what this is actually saying—that the return is pretty closely matched to what the yield is that you'd be buying that fund right now.
Now on a short-term bond fund, it's not going to hold true, but on something like [Vanguard] Total Bond Market [Index Fund] or the broader [Vanguard Intermediate-Term] Bond Index Fund that's more of—any kind of an intermediate-term bond fund—it's probably going to be a pretty good estimate—and the ingoing yield—the [Vanguard Intermediate-Term] Treasury [Fund] is just going to be a lot lower. The Total Bond Market [Fund] at least has mortgages and corporate in it as well.
So am I saying that, yes, you should have lower expectations? You should build off of what the ingoing yield is that you're buying the bond fund right now. And if that's a lower yield, because we're in a lower-yield kind of financial repression environment, then, yes, you need to build off that lower yield. You need to be realistic in what kind of expectations you should plan for. And I think it can have implications for what else you need to do. Maybe you need to save more because you're recognizing that you're in a forward-looking basis that's a lower-expected return environment. So maybe try to increase your savings during these years while you're still working, and just try to figure out what other dials you can move to try to make it last through retirement.
Amy Chain: I think I'll ask you to chime in, but if I was to say, "what's an investor to make of this?" I think it comes back to some of the things you've already said, Sarah, which are, make sure that the bonds in your portfolio are playing the intended role.
Sarah Houston: Yes, I think that's right. And I think it's also looking at what is that investment strategy? What's your plan? What are your objectives? What are you saving for? And any time you've set out what your goals are, there are going to be constraints, right? How much you have to save, and expectations in terms of what realistic expectations, and what a portfolio could potentially yield. That's one aspect of that that can be a constraint as well—that I think is important to consider.
Ken Volpert: And there's a danger right now in a low-yield environment that exists is that investors start reaching for yield, and they're doing that by going into riskier and riskier investments, high-yield markets, dividend-paying stocks. I mean, they're trying to use other kinds of investments that are riskier, much more volatile investments as a substitute for fixed income, and it's changing their profile—their risk profile.
Amy Chain: We have a live question that came in from Tom. Tom says, "Shouldn't we replace bonds with dividend-paying stocks?" Careful there, Tom.
Sarah Houston: Yes, that's exactly what Ken is saying, is that I think people are looking potentially for additional yield, and the reality of a dividend-paying stock fund is that it is a stock fund, it's equities, it is not a bond fund. That doesn't inherently make it bad, but what it does do is that, if you start moving towards investing in products like that, then you are deviating from what your risk return profile is by the asset allocation that you've—and that may be fine as long as you understand that you're taking on a different risk profile, and it's a more aggressive risk profile because it is equity.
Amy Chain: Thank you, Sarah. Ken, I'm going to ask you a technical question. This question comes from Paul in Minnesota. Paul says, "When the NAV of a bond fund drops, does it affect the monthly distribution dollar amount? In other words, if we rely on the income amount from a bond fund, why should we care when the NAV goes up and down, when we plan to hold the fund for the long term?"
Ken Volpert: I think Paul brings up a really good point. If an investor is investing for income they really want—I think if you buy a bond fund that throws off a certain dividend each month that is what you're looking to live off of, you shouldn't be that worried about it moving up and down in terms of value, because you're really buying that dividend stream or that income stream. And, hopefully, you're buying a long-enough bond fund to give you that income stream.
Amy Chain: Maybe just to time you out here for a second, explain for our audience what NAV actually means on a bond fund.
Ken Volpert: Okay. NAV is the net asset value, so it's the price that the fund is trading at that you can see in the paper each day or see on Vanguard's website. So that's what net asset value is, and the dividend is actually the monthly payment that comes—so many cents per share.
Amy Chain: Sort of a collective distribution of all of the bonds that are held in the portfolio.
Ken Volpert: Exactly, to each share of the fund. So that income stream—longer-term bond funds actually have a more durable income stream.
Amy Chain: "Durable" meaning?
Ken Volpert: "Durable" meaning it's not going to change that rapidly if interest rates change. Because it's buying longer-term bonds, and it's already locked in those longer-term bond yields, it's going to have that yield for a longer time period. But longer-term bonds also have more variable NAV—net asset value, right?—because they have longer duration, and as interest rates move—or longer average maturity—and as interest rates move, those bond prices are going to go up and down a lot more variability than the short-term bond funds are going to have.
But let me just say on this question, because if you imagine that you have a certain amount of dividend coming off of the funds and it's reinvesting those dividends. A lot of investors, most investors, in fact, reinvest their dividends every month. Not that many actually take the income. And we saw that in the first question that was asked: 78% users diversified and only a smaller percent, 22% I guess, actually took the income off of it.
So most investors you really do have are diversifying and they reinvest those dividends back into new shares. So if the shares drop, you can imagine that that dividend is going to be reinvesting to be able to buy more shares. You know if the price actually went up you'd be buying less shares and it would be hurting your dividend over time. But if the price actually goes down you're able to buy more shares than you would otherwise be able to buy, and so the dividend collectively of the whole portfolio that you hold is actually going to go up a little bit more.
That's an important point that investors need to realize is that if interest rates rise, meaning that net asset values decline, the reinvest of those dividends are actually getting more shares than you would have otherwise be getting and going to be leading to higher dividend over time than you would otherwise be getting.
So this is the "interest on interest" point. So even though you lose on price, the reinvestment rate of what you're going to be getting is going to be higher in the future if interest rates rise. And those too have some degree of offset. And the longer the bond fund is, the more difficult it is for that offset to be overcome if interest rates rise. The shorter the bond fund is, the more quickly the reinvest can make up for the decline in price.
So that's something that I think is another aspect that's important for investors to understand.
Amy Chain: Well stated and I like that "interest on interest." That's a great little sound bite. Thank you. For those retirees that are looking for income, Sarah, I'm going to send a question your way. Ron from Maine asks, "I'm a retiree and I need income from bonds, but to help protect my principal as interest rates increase over future years, should I look to investing in floating rate bonds? If so, what percentage of a predominately fixed portfolio would you target?"
Sarah Houston: It might help to start by sort of defining what a floating rate bond is, in case everyone is not familiar with that. A traditional bond actually has a fixed coupon rate as opposed to a floating rate. Instead of it being fixed, it's really tied to some other type of measure like a Fed fund rate, or a LIBOR, or something like that plus something above that. So the rate actually moves on it, it's reset maybe every 30, 60, 90 days.
What's important to know about floating rate bonds is that in reality they have the characteristics much more of a high-yield fund than a high-quality bond. So what you're doing is, you're actually—yes, floating rate bonds do tend to minimize the interest rate sensitivity to the extent that there are fluctuations in interest rates. But what happens is you're taking home more credit risk to do that.
Amy Chain: Talk to us a little bit about what credit risk is.
Sarah Houston: So in terms of the actual underlying, who have you borrowed from. And it's more similar to some of the risk that you might take on in equities as well. So the credit risk you just have a more like a high-yield junk type of bond.
Amy Chain: So you can track sort of a Treasury bond with a high-yield bond to see what the differences are between the two. A high-yield bond probably has returns more correlated with stocks at times—
Sarah Houston: Yes, that's right.
Amy Chain: Than a Treasury bond, which is sort of more secure.
Sarah Houston: And I think you hit on another important point is that when you start to deviate and you replace the sort of high-quality bonds in your portfolio with high-yield or floating-rate things that have more significant credit risk, you actually are losing some of the diversification benefits that you would get, because it has less impact in terms of really the volatility of stocks.
Ken Volpert: This ability to rebalance, which is so important to rebalancing. If the stock market drops a lot, you want an asset that actually is going to hold its own or actually be increasing, offsetting that. If you have an asset that also is going to drop a lot, much like a high-yield fund and like bank loans that are also high-yield floating rate securities, they would drop a lot if the stock market was down 30%, those bank loans, which are high-yield loans made to highly leveraged companies, they're going to drop. So the rebalancing aspect is not going to be that helpful to you to get back into mix, because you're probably going to be pretty close to the same mix that you were originally just a lot lower assets.
Ideally what you want to be able to do is have something that's appreciating, like government bonds do, or a total market fund generally would do better during that period, and be able to sell some of that and buy some of the underperforming equity assets in that example.
Sarah Houston: There's another part of Ron's question I think—which really touched on—I think he started off saying he was a retiree and he was looking for income. And one of the things that we actually hear from a number of our clients that are retirees, particularly in Flagship®, is that they're looking for additional income, and the way that they are actually approaching how to use their income is it's an income-only approach to drawing down on their portfolio. And what Vanguard actually—our research—in practice what we do and our financial planners here use is a total-return approach to spending. So instead of just looking to what's the income that's coming off of a portfolio, looking at the income and really total return that's coming, so what's coming also from capital gains, and making use of that.
There are actually a lot of advantages. I think emotionally people don't necessarily like the idea of going to what's the total portfolio and drawing from that. But the reality is, in terms of the implementation, a lot of tax efficiency. You actually increase the longevity of your portfolio. You can maintain the asset allocation diversification potentially better. The only thing that's a little more difficult sometimes is the implementation of that.
But it's something that we are here as a resource, because what we're finding is that can be a much more valuable approach for retirees particularly as they look at how to draw down and use their portfolios.
Amy Chain: So we've talked a little bit about investors who are using bonds for income. We have a question from an investor who is not using bonds for income. We've got lots of live questions coming in today, so thanks for the engagement, audience. Doug from Florida, thanks for tuning in. Doug asks, "When interest rates rise if I am not looking for income but will need the net asset value due to my age, should I change from the total bond market to short-term and/or intermediate-term bonds?" This is really an allocation question. What's the right type of approach to bonds if you're not using them for income?
Ken Volpert: So let's talk about the index instead of talking about the fund. But the index that it's benchmarked off of is largely Treasuries and mortgage securities, which would do pretty well. Actually, if the stock market sold off a lot, interest rates would go lower, and you would get some price appreciation from interest rates going lower, plus the coupon that it has.
So you would have a positive return from the total U.S. bond market exposure, and you'd have negative return on the equity, so you can do some rebalancing and hopefully get positioned by being able to buy more of that lower, underperforming equity asset in that example.
If you were in short-term bond funds, you'd still have to be able to do the rebalancing but probably not as much of the rebalancing, because you didn't appreciate as much in that kind of a bond market rally as the longer bond fund would have.
So I think getting back to the question that this investor had, I think whether they use total bond market or whether they move shorter really depends on how quickly they think the market is going to normalize.
If they think over the next year or so the market's going to normalize, that's a faster time period than the market itself is pricing in the normalization of the yield curve. It's pricing in over three years that's it's not going to happen. So if they think it's going to happen like over the course of the next year, and the economy really is going to gain a lot of strength, and the Fed is going to have to start slowing down the quantitative easing, and interest rates are going to go back up quickly, then the shorter-term bond fund would probably do better than total bond market.
Amy Chain: They may want to consider the shorter-term bond market.
Ken Volpert: They may want to consider that, but they should realize that it's an active decision; that it's different than owning the market as a whole. And one of the beauties of owning the market as a whole is everybody else in total is the market as a whole. So if you could own the market at a lower cost, you should do better than average over longer periods of time. That's the whole indexing argument.
So once they move away from that they should realize they're moving away from a market cap weighted or a broad index approach to investing that could lead to them actually underperforming the average if they're wrong. Important for them to realize.
Amy Chain: I'm going to stay with you Ken. We have a couple of questions that I've seen come through on some of our bond funds. Let's take one from Nancy from Denver. Nancy says, "How should we add Vanguard's new [Total] International Bond Index Fund to our portfolio?" I think we should pause first and talk about what this new fund is. Ken, maybe you can take us through that and then, Sarah, maybe you can tell us how an investor might what to think about it.
Ken Volpert: Sure. So we have a couple of new funds that are coming out within the next couple of months. We have an international bond fund that is buying—just like we have total bond market that invests in the U.S. bond market, we have total international that invests in everything outside of the U.S. that's investment grade. So invests throughout Europe and Asia, that are investment grade governments, and corporate, and asset-backed, and then it hedges that back to the U.S. dollar. So it's a fully hedged, 100% hedged back to the U.S. dollar.
Amy Chain: That's an important phrase when you're talking about international bond investing.
Ken Volpert: Absolutely.
Amy Chain: Hedged or unhedged can really change the nature of a fund.
Ken Volpert: It's very different if you're unhedged. Unhedged—actually the volatility of the currency dominates the risk in an unhedged bond fund. And the bond market exposure is actually a pretty small portion of the volatility. But what we think makes sense—and we've got research that has been done on this at great depth—when you hedge it back it actually creates a bond market portfolio that is about comparable to the volatility of total bond market, but it's different drivers, it's different economies that are causing the market to do well, rates to go up or down, and so it's not perfectly correlated. And that lack of a perfect correlation, when combined, actually reduces volatility in the portfolio.
And as long as the expected return is about the same, if we could have lower volatility and about the same expected return, that improves the risk profile and the return profile of a fund.
And so that's why we're getting ready to launch this fund and we're including it in our Target Retirement Funds also. And then we have an emerging markets, U.S. dollar-denominated [Vanguard Emerging Markets Government Bond Index Fund], so it's buying U.S. dollar emerging market government bonds as another fund option that's available out there for investors.
Amy Chain: Tell me what that means. What would be the alternative to U.S. dollar emerging market bond funds?
Ken Volpert: There are emerging market bond funds that are buying local currency, basically buying the emerging market bonds in those emerging markets' own currencies. A lot of emerging market countries choose to go to the U.S. dollar market to actually list issues. And so those are the ones that we would be buying because we don't want currency risk in this fund for emerging markets. So it's a chance for investors to get exposure to improving fundamentals and what's going on in terms of natural resources that a lot of these emerging economies have available to them, and be able to do it without currency risk through our U.S. dollar funds.
Amy Chain: Sarah I would love it if you could talk about how these fit into a portfolio. And we've actually had a question come in from Allen in Connecticut who wants specifically to know about why you would invest in international versus domestic bonds. So you maybe you could fold that into your answer about how an investor might consider using this fund.
Sarah Houston: I think Ken really touched on already that for an average investor, that getting exposure to international bond funds really does help mitigate, even further the risk in a diversified portfolio, or the volatility, sorry, in a diversified portfolio. You know there's not an optimal allocation for every investor in terms of the research that Ken also alluded to. What we do know is that some exposure is better than none.
Ken also mentioned that we are adding it to our Target Retirement Funds when we do launch them, and it will actually make up about 20% of the fixed income allocation in those funds.
Amy Chain: Twenty percent of the fixed income allocation, not of the total portfolio.
Sarah Houston: That's exactly right. So I think that's probably a good starting point from which someone can think about and make their own decision. But I think if they are so inclined to add it, that's probably a good guideline to start from.
Amy Chain: I think I hear you saying think about 20% of a bond portfolio from an international perspective, and think of international for its diversification benefits. Is that the right way to summarize how to think about this?
Sarah Houston: Exactly.
Amy Chain: Well we are getting close to time here, so maybe we have time for one more question.
Ken Volpert: Can I just interject with one thing? Because one other change that we have in the Target Retirement [Funds] that kind of ties into something that maybe investors are interested in.
Amy Chain: And this will be a fund near and dear to your heart as a portfolio manager for many years.
Ken Volpert: So we're moving the allocation from our TIPS [Vanguard Inflation-Protected Securities] Fund in the target retirement portfolios to a new index fund that was created that's a zero- to five-year short-term TIPS [Vanguard Short-Term Inflation-Protected Securities Index Fund]. And the reason that we're doing that is—what we found is that broad, longer-duration TIPS fund is actually—hasn't really hedged inflation very well. It has earned the inflation, but it's also got a very large exposure, about an eight-year duration or interest rate risk to real interest rates, which have come down a lot. So when you look over the last 10 years, the TIPS fund has actually earned about 6% return; inflation has only been about 2.5%.
Amy Chain: Tell us a little bit about TIPS, and how TIPS fall into a portfolio.
Ken Volpert: So TIPS are Treasury Inflation-Protected Securities; they're types of bonds that pay you a real interest rate, which means, before inflation it pays you a rate and then on top of that you earn whatever actual inflation is. But the average maturity, if you will, of a TIPS fund is about close to 10 years. So you're actually buying a lot of interest rate risk, that real interest rate risk, which has been really helpful to the investors in the Target Retirement Funds, but it actually hasn't correlated very well with inflation. It hasn't been a good inflation hedge in the sense that it's given a lot more return because interest rates have declined than what the actual inflation rate has been.
And so what we've looked at, and the research we've looked at, we actually find that short-term TIPS are actually a much better hedge against inflation. Correlation is almost twice as high with actual inflation as the TIPS fund out there.
And that's why we own TIPS in the Target Retirement Funds as an inflation hedge. So we want to move out of the TIPS actively managed fund [Vanguard Inflation-Protected Securities Fund] and move that into the short-term fund Vanguard Short-Term Inflation-Protected Securities Index Fund] so that we can have a better matching or more high correlation with actual inflation or unexpected inflation going forward.
Amy Chain: Thank you. While we're talking about TIPS, which clearly can be bought as individual bonds, I'm going to ask you a question, Sarah, that comes from Diane in Kansas. Diane's question is not about TIPS specifically, but she says, "What are the advantages of buying bonds versus individual bond funds?" And I'll give you a qualifier; we're getting close to time so we'll have to be concise.
Sarah Houston: Fair enough. The shortest answer is that for the vast majority of investors, then they are going to have far more advantages to buying a low-cost mutual fund than they are individual bonds. And that's really largely due to buying power and scale, frankly.
Because of the scale that mutual funds have, then generally an investor is going to see better diversification, they're going to see more efficient management of the cash flows, low cost. All of those things generally, because of the scale that you have in a mutual fund, that's going to be—
Amy Chain: Gives you the ability to buy many bonds.
Sarah Houston: That's exactly right, and I think that's particularly true in the corporate and municipal markets.
Amy Chain: We're just about out of time. I'll ask you two if you have any closing thoughts to share with our views today.
Ken Volpert: We did cover a lot, a lot of really good questions. Two key points I think really tie into those graphs that we talked about, both graphs that we looked at really, is key themes I would say hopefully investors are going to take away. One is that the current yield that you're buying into a bond fund right now is a pretty good—especially for total bond market or an intermediate-term bond fund—is a very reasonable expectation for what you should be expecting in the next period over the length of that investment, which should be about 1.8% return right now on something like total bond market. And then the equity return risk premium is what you're probably going to earn above that, or what you should expect to earn above that.
So realistic expectation is really important, and what are the implications that that means for you around what else you need to do as an investor and as somebody who's preparing for retirement in terms of savings, or in determining how long you're going to work, or how you're going to live in retirement, etc. Those all need to come into play and be evaluated.
And the second thing is just the importance of discipline in rebalancing your portfolio, especially after big market moves, because that's when you can actually move from the outperforming asset into the worse-performing asset and be able to capture that value, or the opportunity, or basically being able to buy at a lower price, which is I think ultimately the goals that investors should have.
Sarah Houston: I think that's very well said and a nice summary. The only thing that I would add to that is for our viewers to keep in mind that we have a lot of resources here at Vanguard to help investors work through these questions. To think about strategic asset allocation if they haven't set that already, but then also to think about, with the current challenges, what might the implications be. And specifically for those 35% who I think are considering but haven't yet made any sort of change, we'd really love to talk with them.
Amy Chain: Great. Well thanks to you two and thanks to all of you for joining us this afternoon. You'll receive an e-mail from us in coming weeks with a link to a replay and also a transcript of today's webcast. And if we could have just a few more moments of your time we'd love it if you can take a quick survey for us. It should appear as soon as you close your browser.
So from all of us here at Vanguard to all of you there at home, have a great day.
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