While the return outlook for the fixed income sector is cloudy, Vanguard strongly believes that bonds can have an important place in investors’ portfolios. After all, they could provide two crucial benefits:
- Providing stability and diversification. As Mr. Buckley said, when the stock market zigs, the bond market often zags. Given the lower historical volatility of bonds versus stocks, and their smaller historical downside risk, Vanguard believes the key benefits of fixed income investing should endure in the years ahead.
- Providing income. Despite the low-yield environment, bond fund investors can benefit from rising interest rates because maturing bonds and new assets can be reinvested into higher-yielding bonds. Rising interest rates can still have a material impact on the prices of the underlying bonds, but the ability to reinvest in bonds with higher yields helps to offset the decline in price.
How we manage our portfolios
Vanguard’s active fixed income funds are managed in a highly risk-controlled fashion, but the funds’ managers do have the flexibility to adjust the portfolios’ durations and yield curve positioning based on the interest rate environment and outlook.
While certain funds (Short-Term and Intermediate-Term Investment-Grade, Short-Term and Intermediate-Term Treasury, and Short-Term Federal) maintain strategically shorter duration targets relative to their benchmarks, representing a long-term view of attractive yield curve positioning, Vanguard’s taxable corporate bond funds are generally maintaining a “duration-neutral” profile at this time.
Cutting risk by cutting duration?
In a recent webcast, Mr. Tim Buckley reminded investors that shortening duration in anticipation of potential interest rate changes is a form of market timing.
While we understand investors’ concerns and the natural inclination to “do something,” it’s important to also understand that the yield curve doesn’t necessarily move uniformly across maturities. Even if rates of short-term and long-term bonds increase together—not always the case—there’s no assurance that they will rise at the same rate. In fact, short-term rates can rise more than long-term rates, an outcome realized in more than half of the Vanguard Capital Markets Model’s hypothetical scenarios. If that were to happen, shortening your duration to lessen your interest rate risk could potentially result in larger losses than if you maintained broad diversification.
IMPORTANT: The projections or other information generated by the Vanguard Capital Markets Model (VCMM) regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results.
Notes:
- All investments, including a portfolio’s current and future holdings, are subject to risk.
- 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.
- While U.S. Treasury or government agency securities provide substantial protection against credit risk, they do not protect investors against price changes due to changing interest rates.
- High-yield bonds generally have medium- and lower-range credit quality ratings and are therefore subject to a higher level of credit risk than bonds with higher credit quality ratings.
- Past performance is not a guarantee of future results.
- Diversification does not ensure a profit or protect against a loss in a declining market.
- The Vanguard Capital Markets Model is a proprietary financial simulation tool developed and maintained by Vanguard’s primary investment research and advice teams. The model forecasts distributions of future returns for a wide array of broad asset classes. Those asset classes include U.S. and international equity markets, several maturities of the U.S. Treasury and corporate fixed income markets, international fixed income markets, U.S. money markets, commodities, and certain alternative investment strategies. The theoretical and empirical foundation for the VCMM is that the returns of various asset classes reflect the compensation investors require for bearing different types of systematic risk (beta). At the core of the model are estimates of the dynamic statistical relationship between risk factors and asset returns, obtained from statistical analysis based on available monthly financial and economic data from as early as 1960. Using a system of estimated equations, the model then applies a Monte Carlo simulation method to project the estimated interrelationships among risk factors and asset classes as well as uncertainty and randomness over time. The model generates a large set of simulated outcomes for each asset class over several time horizons. Forecasts are obtained by computing measures of central tendency in these simulations. Results may vary with each use and over time.