Keep It Short-Term for Now

09/22/2006 12:00 am EST


Daniel Wiener

Editor, The Independent Adviser for Vanguard Investors

Vanguard expert Dan Wiener analyzes the bond market in light of the uncertainty regarding the Federal Reserve's next rate movements, and suggests that investors keep their dollars close by taking profits in long-term bonds and investing now in short-term funds.


"The round-trip that bonds have made over the past few months has been remarkable. The yield on the ten-year Treasury bond, which climbed to 5.25% just two months ago, dropped below 4.75% in August. Long-Term Treasury, down 5.4% for the year at the end of May, has now erased virtually all of its losses for the year. I don't believe this will last, and if you've been waiting for a good exit point from the bond market, this might be it.

  "Yields have been sliding back down as bond prices have rallied on expectations that the Federal Reserve is either finished or nearly finished hiking interest rates, and inflation appears to be under control. The latest Producer Price Index and Consumer Price Index numbers have showed a slowing in the pace of inflation's advance. Bond investors have gotten a little ahead of themselves given inflation remains above the Fed's comfort zone. As bond prices have risen, they've driven the yield on the ten-year Treasury as low as 4.72%. The Treasury bond's yield at month-end was 4.73%.

"Clearly, long-term funds like Long-Term Treasury, Long-Term Bond Index, and Long-Term Investment-Grade have had a nice rebound of late. Since hitting recent lows in late June, prices for the three funds have rallied anywhere from 4.9% to 5.6%. But I'm not convinced the Fed has slain the inflation beast at all, notwithstanding the recent PPI and CPI reports. Oil's fall near $70 per barrel didn't last long. And oil has been driving much of the inflation news (along with rent hikes, as consumers have turned to renting over buying). This means yields could go right back up, and prices down again, handing more losses to long-term bond investors who think they're now out of the woods.


"This is not the time to extend the duration of your portfolios by buying longer-term funds. The pain in the bond market is not over yet so I'd continue to stick with the safe and solid choices available among shorter-term funds like Short-Term Investment-Grade (VFSTX) , which currently yields 5.12%. And of course, cash remains a good, ultra-safe option with Prime Money Market (VMMXX) , yielding 5.11% at month-end. Why extend out to a fund like Long-Term Treasury, currently yielding 4.83%, when you can keep it a whole lot safer in short-term funds?"

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