Get Ready for Rising Rates

05/11/2009 12:11 pm EST

Focus: FUNDS

Daniel Wiener

Editor, The Independent Adviser for Vanguard Investors

Dan Wiener, editor of the Independent Guide for Vanguard Investors, finds three bond funds that should do well when the economy recovers and interest rates rise again.

The real question bond fund investors should be asking today is what kinds of returns can be expected from bond funds in the coming years. Bonds have been on a tear, and when the credit markets went into lock-down last fall, investors were literally gobbling up every Treasury they could get their hands on, bidding up prices in the process.

Since hitting their lows, bond prices have moved down a bit and yields have risen-but not a lot. Should inflation come back, or investors begin moving out of Treasurys into other securities, yields will rise and prices will decline further. [Still,] rising interest rate environments are periods when bond fund investors actually do a little better than their "buying yield" or "starting yield" would suggest.

Vanguard Short-Term Investment-Grade (VFSTX) is my favorite fund at the short end of the yield curve. Because the fund doesn't invest in government-backed securities, it took a beating when credit markets seized up. But it's already on the road to recovery. And who can look askance at a yield of 4.58% when the comparable Treasury fund yields just 1.11%? I use this fund as a higher-yield cash substitute and would recommend it in that role for most any portfolio invested for the long haul.

Inflation is certain to return, but probably not just yet. But this is probably a good time to begin easing into Vanguard Inflation-Protected Securities (VIPSX) if you're worried about future inflation, or just want to boost returns over Treasuries.

The idea is for investors' real returns, or returns above and beyond inflation, to remain constant. You want to own this fund when inflation is on the rise and avoid it when deflation abounds. When to buy or sell is not always obvious, but we're at something of an inflection point now, hence my suggestion that you may want to ease in here.

Until last fall, when Inflation-Protected Securities' yield was actually higher than the Vanguard Intermediate-Term Treasury (VFITX) fund's yield, the smallest gap, or spread in yields, was an 88 basis point difference in January 2001. Five years later the inflation fund had returned 8.1% annualized versus 5.5% for the Treasury fund.

So, while December might have been the best time to buy this fund, I think it's still an opportunity for longer-term investors today.

This fund is anything but tax-efficient, since both its income and the periodic price changes in the underlying securities are fully taxable. It is best used in a tax-deferred account such as an IRA.

Closed and re-opened, Vanguard High-Yield Corporate (VWEHX) is a fine "junk bond" fund, combining decent yields with relatively low risk compared to others in its category. While it may lag when other junk bond funds are soaring, it loses much less when times are tough. This is key, as it is statistically easier to recover from smaller losses than it is from the big ones.

Subscribe to The Independent Guide for Vanguard Investors here.

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