Using bonds wisely

Hear what the expectations are for bonds in today’s market climate.

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Rebecca Katz: Well, so you mentioned bonds and that you use them as ballasts, but what is our outlook for the bond market in 2018, Greg?

Greg Davis: So, when you think about the bond market, again, the best place to start is looking at starting yields in the broader bond market. And so, based upon where we are in the yield environment in the U.S. market globally, we’re expecting 10-year average annual returns to be somewhere between 2 to 3%. Again, lower than historical norms, but we’re starting at a lower level of yield and a bond is nothing more than a series of coupon payments and that maturity of that principal payment. And in this type of environment, we’re expecting, again, more muted level returns in that market.

But to Tim’s earlier point, it’s a key provider of that ballast in a portfolio. So, when you do have that pullback in the equity markets, you will have an opportunity to have an asset class that’s going to provide some diversification that will give you some power to rebalance into the equity markets which could be lower at some point in time.

Rebecca Katz: Well, if we’re expecting lower returns in the bond markets, we had a question come in through Facebook again asking, “If rates are going to rise, are there certain types of bonds you should look at?” Again, I think we have this issue of when interest rates rise, bond prices fall, so what types of bonds should you be looking towards?

Greg Davis: So, again, I would start with when you’re thinking about the diversification aspect of bonds, the first thing I’d say you want high-quality bonds first, so Investment-grade whether or not they’re corporate bonds, government bonds, things of that nature but very high quality because when you start venturing into high-yield, it has more equity-like characteristics, and they’re not going to provide that same level of ballast. So, when we think about a rising rate environment, it really depends on an investor’s time horizon. So, if you’re a long-term investor, if you own a short-dated bond fund or an intermediate-term bond fund, rising rates are actually a really good thing for you because that long-term time horizon, you have the benefit of those bonds, as they mature and coupons get paid, they’re being reinvested at a higher yield. So that’s ultimately going to return a higher total return for an investor in a rising rate environment than it would in a stable environment, again, for long-term investors.

Rebecca Katz: Yes. If you have a short-term, then you probably should align with more of a short-term bond.

Greg Davis: Exactly.

Rebecca Katz: Okay, great. Well, we’ve covered interest rates and stock valuations I think. Let’s see. We have a lot of questions. We get thousands of questions when people register online so it’s very hard to pick the favorite ones. But let’s stick with the fixed income space. And Doug in Manheim, Pennsylvania, said, “What’s our view on the yield curve in 2018?” And, again, just because I didn’t know what a yield curve was when I first started at Vanguard, if you can explain that and then explain your view?

Greg Davis: Sure. So, when you think about the yield curve, the yield curve is basically just plotting the various maturity points when it comes to the Treasury market. So, you can start off at the very short end with 3-month Treasury bills, 6-month bills, 2-year bonds, 5-year, 10-year, and 30-year bonds. And all those plots, if you connect it with a line, that’s going to give you a yield curve.

Rebecca Katz: So, it’s just their yields, their interest rates on those bonds.

Greg Davis: That’s exactly it. That’s exactly it. And you plot the line between those points that’s going to give you a curve to some degree. Normally that curve is upward sloping because most investors, if they’re going to lend money, they expect to get paid more if they’re going to lend money for a longer period relative to a shorter period.

Now what we’ve been seeing recently is because the Federal Reserve has been quite active in terms of raising rates—they raised rates in December of ’15, December of ’16, and then three times in ’17—we’ve seen the short end of the yield curve 2-year rates, 3-month bills, and all that rise. And, basically, over the last year or so, the 10-year Treasury has basically stayed the same. So we’ve seen what we call a flattening of the yield curve because the front end went up and the middle part of the curve basically stayed anchored.

Going forward, it’s really going to be dependent upon how aggressive the Federal Reserve acts and, also, a function of, well, what’s happening in the economy and inflation? To the extent that inflation starts to pick up, that’s where the longer end of the yield curve, 10 years and beyond, will be at somewhat of a risk to rising rates.

Rebecca Katz: Okay, so the longer bonds are much more sensitive to inflation.

Greg Davis: To inflation.

Important information

All investing is subject to risk, including possible loss of principal.

Diversification does not ensure a profit or protect against a loss.

Bond funds are subject to the risk that an issuer will fail to make payments on time, and that bond prices will decline because of rising interest rates or negative perceptions of an issuer’s ability to make payments.  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.

For more information about Vanguard funds, visit vanguard.com to obtain a prospectus or, if available, a summary prospectus. Investment objectives, risks, charges, expenses, and other important information about a fund are contained in the prospectus; read and consider it carefully before investing.

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