(02/11/16) Vanguard's Fixed Income Trio

It’s tough to be a fixed income investor these days. On one hand, yields of the highest quality bonds are so low they are hardly worth the risk that interest rates will rise, causing their prices to fall, explains Mark Salzinger, editor of No-Load Fund Investor.

On the other hand, while high yield, low quality US corporate bonds now offer yields of 6%, 7%, or more, their investors face an increasing probability of downgrades and defaults.

So, what’s a fixed income investor to do? We suggest splitting the difference between the highest and lowest quality US bonds by focusing your bond portion on funds that invest in medium quality corporate bonds.

These provide more yield than US Treasuries, with more safety than high-yield US corporates.

Vanguard offers three pure play index funds on medium quality corporate bonds, differentiated by maturity.

Short Term Corporate Bond Index Fund (VSCSX) offers a current SEC yield of 2.24%. The fund invests in US corporate bonds with maturities of between one and five years, for an average of 2.9.

While high grade corporates account for about 12% of assets, the vast majority of the rest goes to bonds with middling investment grade ratings, split virtually evenly between A and Baa, the lowest investment-grade rating.

Intermediate-Term Corporate Bond Index Fund (VICSX) offers a current SEC yield of 3.60%. Unlike its short-term sibling, this fund charges a purchase fee of 0.25%.

The fund invests in bonds with maturities of between five and ten years, for an average of 7.4 years and duration of 6.4.

Higher grade, Aa-rated bonds account for 7% of assets, while A-rated get 37% and Baa, 54%.

Long-Term Corporate Bond Index Fund (VLTCX) offers a current SEC yield of 4.94%. It charges a purchase fee of 1%, so buy this one only if you plan to hold it for the long run.

It invests in US corporate bonds with maturities of greater than ten years. The average maturity of its holdings is now 23.8 years, with an average duration of 13.4. So, its higher yield is coupled with significantly higher interest-rate risk than that of its siblings.

Considering the three funds, Short-Term has provided the smoothest returns, though with less longer-term gain. Long-Term has produced the highest long-term gain, but with considerable volatility.

Most investors may be best served by Intermediate-Term, which we believe offers the best balance among yield, stability, and the potential for long-term total return.