(PUB) Investing 2015

fund), you are really picking between price stability and income stability. As a side note, every year in the annual Independent Guide to Vanguard Funds , you can find the two components of a bond fund’s total return—its income return and its capital return—in the Details table on each fund’s profile page. Safety orYield But investing in bonds and bond funds isn’t all interest rates and maturi- ties. Not only do you need to decide how long you want to lend money for, but you also need to decide who you want to lend that money to. Many different types of entities need to borrow money, and not every one of them is equally likely to be able to meet their obligations to both continue paying their promised inter- est and pay you back your principal. In bond lingo, the risk that the bond issuer may be unable to pay back the money it borrowed is called either credit risk or default risk . Bonds issued by the U.S. Treasury are often referred to as “risk-free” because investors see the U.S. govern- ment’s default risk as minimal to non- existent. The government can always raise taxes or print money to cover its obligations. Of course, Treasury securi- ties are still subject to interest-rate risk, so they really aren’t risk-free unless you hold them to maturity. Bonds issued by corporations gener- ally carry a higher risk of default. When lending to an entity with greater default risk, lenders (the folks like us who are buying the bonds) want to be compen- sated for this risk, usually in the form of a higher yield. If you are buying a bond fund, default is generally not a concern, as the funds are diversified to the point that one company defaulting won’t derail overall performance—this is especially true at Vanguard, where funds often hold more than one thousand indi- vidual bonds. However, even ignoring default risk, there are still trade-offs to consider when deciding between the safety of Treasury bonds and the higher yield of a corporate bond-ori- ented fund, like Intermediate-Term Investment-Grade .

Protection From Falling Stock Prices…

…Versus Sensitivity to Rates

-1.25% -1.00% -0.75% -0.50% -0.25% 0.00% 0.25% 0.50% 0.75% 1.00% 1.25% 1.50% 1.75%

-0.75% -0.50% -0.25% 0.00% 0.25% 0.50% 0.75% 1.00% 1.25% 1.50% 1.75% 2.00%

Int.-Term Treasury Int.-Term Invest.-Gr. High-Yield Corporate

Int.-Term Treasury Int.-Term Invest.-Gr. High-Yield Corporate

Avg. Monthly Return When 500 Index is Down

Avg. Monthly Return When 500 Index is Up

Avg. Monthly Return When Yields Fall

Avg. Monthly Return When Yields Rise

Treasury rose or fell. All three funds did better on average when yields were fall- ing—no surprise there. Treasurys were the most sensitive to changes in inter- est rates, performing best when yields fell and dropping when yields rose. Compare that to High-Yield Corporate, which delivered positive returns on aver- age when rates were rising. This is partly due to the higher yield of the junk bond fund helping to offset the impact of fall- ing prices, but keep in mind that rates tend to rise when the economy is doing well—a good environment for more risky corporate issuers. In sum, the charts describe the trade- off between Treasury and corporate bonds: Treasurys offer more down- side protection when stocks fall, but carry more interest-rate risk. Corporate bonds don’t offer as much of a buffer when stocks are falling, but are less sensitive to swings in interest rates. For my money, Intermediate-Term Investment-Grade—with a portfolio that is predominately invested in high- quality investment grade-rated corpo- rate bonds—has balanced the trade-offs between interest rate and credit risk well, and with its higher yield, should continue to outperform Intermediate- Term Treasury over the long run. Inflation Risk Another risk, hidden yet insidious, is inflation risk , or the risk that a bond’s return may not keep up with inflation. As you know, inflation is a broad increase in the prices of goods and services. One outcome of inflation is that your purchasing power decreas-

Bonds issued by companies with greater credit or default risk tend to be more sensitive to the economy than to changes in interest rates. Why is that? As a rising tide tends to lift all ships, a growing economy makes it easier for even less financially stable companies to pay back their debts. But a faltering economy can be enough to derail those same companies and damage their abil- ity to make bond payments. (This is particularly true when we start talking about high-yield bonds, or junk bonds, which are rated below investment grade and are the most likely to default.) While corporate bonds are less sensi- tive to changes in interest rates, being tied to the economy means that they are more apt to be buffeted by the same factors that move stocks than Treasury bonds are. Consider the charts above showing the average returns of Inter- mediate-Term Treasury , Intermediate- Term Investment-Grade and High-Yield Corporate in different environments. The first chart shows the aver- age return of each bond fund during months when 500 Index was either positive or negative over the past 15 years. In months when 500 Index fell, Intermediate-Term Treasury on average gained 1.0%, which put it ahead of its corporate-bond heavy siblings. High- Yield Corporate actually lost 0.9% on average in months when stocks were in the red. Conversely, when stocks rose, the corporate bond funds outpaced the Treasury fund. The second chart shows the average returns for the three bond funds inmonths when the yield on Intermediate-Term

The Independent Adviser for Vanguard Investors • August 2015 • 13

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