Yes, Some Bond Funds Still Look Good

10/11/2010 12:30 pm EST

Focus: BONDS

Daniel Wiener

Editor, The Independent Adviser for Vanguard Investors

Daniel Wiener, editor of the Independent Adviser for Vanguard Investors, says there are still good yields to be found, if you stay away from Treasury bond funds.

Bond market risk is rising. Investors who've been plowing money into bonds and bond funds, while virtually ignoring stock funds, think they are reducing risk by focusing on bonds. I think they're making a big mistake.

Bonds have been in a decades-long bull market. At the end of September 1981, the yield on the ten-year Treasury stood at 15.84%. Imagine! Yields slid to the December 2008 low [of 2.1%]. But as those yields were sliding, bond prices were soaring. The total return earned by investors in long-term bonds or bond funds was tremendous.

The question now, of course, is when the tide will turn. When it does, yields will rise substantially, and prices will fall.

I think some of the greatest risks lie in the Treasury market. For one thing, yields are so low that investors are really not being paid very much for the supposed safety and security of a US Treasury bond.

For another, the yield spread, or difference between yields on Treasury funds and corporate bond funds with similar maturities, remains wide enough that I think investors are still being paid a decent yield premium to take the risk of owning corporate debt.

On average, [Vanguard’s] three high-quality corporate bond funds' yields have been about 100 to 110 basis points, or 1.00% to 1.10%, higher than the yields on similar-maturity Treasury funds. Today, yields on the three corporate funds—Vanguard Short-Term Investment-Grade (VFSTX), Vanguard Intermediate-Term Investment-Grade (VFICX), and Vanguard Long-Term Investment-Grade (VWESX)—are well above those averages, which means you're still getting paid a nice yield premium by investing in a Vanguard corporate bond fund rather than a Treasury bond fund.

Treasury funds also look unattractive compared to Vanguard's tax-exempt funds. As you might expect, the Treasury funds have typically yielded more than their tax-exempt cousins. Why? Because while income from Treasury bonds is taxed, income from the municipal bonds held in Vanguard's tax-exempt funds generally isn't taxed (at least not at the federal level).

In Vanguard's case, the "yield spread" has generally run, on average, between 70 and 85 basis points, or 0.70% and 0.85%, in favor of the Treasury funds. Today, that relationship has reversed. Tax-exempt funds are actually yielding as much as or more than their Treasury counterparts. Again, the case "against" Treasury funds, and the case "for" tax-exempt bond funds, is pretty stark.

[I find] Vanguard GNMA (VFIIX) particularly appealing given its combination of steady returns and better-than-average yields. [Since the end of April], while Short-Term Investment-Grade's yield has fallen from 2.33% to 1.90%, GNMA's has gone from 3.37% to 3.62%. That's right, it's risen due to some savvy management and vagaries in the market. I recommend sticking with this fund, and I don't think it's too late to hop on board now.

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