Staying Short and Safe

08/25/2006 12:00 am EST

Focus:

Daniel Wiener

Editor, The Independent Adviser for Vanguard Investors

Betting on a cessation of the Federal Reserve’s determined program to boost interest rates, Daniel Wiener makes a case for staying short, safe and focusing on income, by investing in a short-term investment-grade bond fund…

 

“In today’s market, with rates going up, the short-term bond investor has looked pretty smart, rolling over bonds fairly quickly and each time buying new bonds with higher rates of interest. Meanwhile, the long-term bond investor is still holding that bond, possibly purchased some years ago, earning the same yield this month as they did last month.

 

“Vanguard’s Shorter-Term Investment Grade (VFSTX) is my favorite Vanguard fund at the short end of the yield curve. The former Short-Term Corporate is extremely safe, produces steady returns, and offers some diversification that the Treasury and Federal funds don’t. Rather than investing only in Treasury, Agency, or other government-backed securities, Short-Term Investment-Grade invests in high-quality corporate bonds, asset-backed bonds, and a smattering of other non-Treasury securities. The combination responds to rising or falling interest rates less rapidly than Treasuries, meaning that they rise a bit slower when rates drop and fall a bit less when rates rise, since their excess yields protect investors and prices. Over time, a portfolio like this one will outperform a Treasury portfolio, as this one has, with no additional risk.

 

“I use this fund as a higher-yield cash substitute in my Model Portfolios and would recommend it in that role for most any portfolio invested for the long haul. Yes, I realize that over the past year, for instance, Short-Term Investment-Grade has lagged Prime Money Market. But that relationship should change very shortly as the decline in short-term bond prices ends along with the end to Fed rate hikes, and the extra yield available on short-term bonds begins to generate excess return, particularly as those short-term bonds mature and are rolled over into newer, higher-yielding securities.

 

“Of critical importance from a portfolio diversification/safety standpoint is that this fund seldom loses money. Over the past decade, this is the only short-term fund Vanguard offers, which never dipped into the red over any 12-month period. The other funds all showed one-year losses of between 0.3% and 0.7% at their worst. Short-Term Investment-Grade’s worst year showed a 0.2% gain.

 

“Of course, because some of the income earned in the government funds is free of state and local taxes, you might come out slightly ahead in those funds if you live in a high-tax state. But if taxes are a big concern you should probably be considering a tax-exempt fund like Limited-Term Tax-Exempt instead.”

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