(PUB) Investing 2015

ticularly sharp action from the Fed as the fed funds rate jumped from 3.00% to 6.00%. To pull in an example from before the bond bull market began, I looked at one of Vanguard’s oldest bond funds, GNMA , and its worst 16-month stretch, which took place starting in 1981 (Intermediate-Term Treasury only launched in 1991). In each of these hypothetical worst- case scenarios using periods when bonds acted poorly, the balanced inves- tor’s portfolio lost around a third of its value and needed a gain of 50% or so to recover—far better than the investor who avoided bonds completely. It’s possible for stocks and bonds to lose money at the same time, but it is hard to envision a scenario where stocks enter a bear market and bonds decline even more. If you are looking to control your risk and help smooth out the ride, then bonds absolutely still have a place in your portfolio. So, since I’m hoping you’re now thoroughly convinced that owning bonds is part of a good long-term strat- egy, let’s examine which of Vanguard’s myriad fixed-income funds may be appropriate for you. When it comes to bond funds, the Vanguard formula is tried and true, and well-tested: Keeping costs low means the portfolio managers don’t have to take added risk for added income, or as it’s known, to “reach for yield.” Instead, they are able to build plain-vanilla portfolios that have been very com- petitive from both a yield and a total return perspective. I remain confident in Vanguard’s ability to execute these strategies well, both on its indexed and actively managed funds. Remember, The Vanguard Formula

14.1% return from Intermediate-Term Treasury during the financial crisis, we swapped in a difficult 16-month stretch for the bond fund? Take a more recent hiccup in the bond markets—the “taper tantrum” in 2013, for example. The taper tantrum, for those who have forgotten, was the reaction among bond investors to then-Fed Chairman Ben Bernanke’s announcement in May 2013 that the Fed was going to first reduce then eventually stop purchasing bonds. Bond investors sold on the news, and the yield on the 10-year Treasury jumped nearly a full 1% from 1.76% at the end of April 2013 to 2.74% at the end of August that year, an increase of more than 50%. The 10-year’s price dropped 8.1%, and Intermediate-Term Treasury declined 4.3% in four short months. A balanced portfolio that combined the worst stretch in 500 Index’s history with Intermediate-Term Treasury’s run during the taper tantrum would have lost more than our first balanced investor (no surprise there), but still would have come out a good deal ahead of the investor who put all of his money into 500 Index. Even after a 31.2% decline, the taper tan- trum balanced investor would only have needed a 45.4% gain to recover. That’s a far cry from that 104.0% recovery our stocks-only investor needed. The taper tantrum is relevant for investors today because the environ- ment hasn’t changed all that much— interest rates are at roughly the same low level, and the economy is plowing along on a similar slow-growth path. Still, in the table below, Jeff and I ran the numbers using other “worst-case” scenarios. The worst 16-month stretch for Intermediate-Term Treasury came in 1999. 1994 and early 1995 saw a par-

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1990s. It followed that up with an annu- alized return of 6.1% throughout the 2000s. And over the first five and a half years of the current decade, Total Bond Market has returned 3.8% annualized. But with a yield of 2.12% at the end of August, I would expect the fund’s annual returns over the next 10 years to run a lot closer to 2% than 6% or 7%. The days of owning bonds for growth and capital appreciation are behind us. But those weren’t the real reason to hold bonds in the first place. Historically, you and I have owned bond funds to generate income and pro- vide a counterbalance to stock market declines. I still think bonds will serve the important role of shock absorbers in our portfolios in the years to come. We only need to look back to the 2008 credit crisis for an example. Stock prices were cut in half over the 16 months from the end of October 2007 through the end of February 2009. 500 Index fell 51.0%. At the end of that period, an investor whose portfolio held nothing but shares in 500 Index required a 104.0% gain just to recoup those losses. Compare that to an investor with 60% of her assets invested in 500 Index and 40% in Intermediate-Term Treasury . With Intermediate-Term Treasury up 14.1% over the same 16-month period, this balanced inves- tor was down 24.9%, or just about half of the loss incurred by someone with all their money in stocks. Seeing your account lose a quarter of its value can be stressful, but it’s far more palatable than seeing your account cut in half. Plus, the balanced investor only needed a gain of 33.2% to recover and resume building profits. Again, to put that into perspective, after bottoming out at the end of February 2009 (using monthly data), the all-stock investor would have had to wait until August 2012 to recover the losses, whereas the balanced inves- tor would have recovered and begun to earn new profits by October 2010—a difference of almost two years. Now, let’s make the comparison even tougher on the bond side of the ledger. What if, instead of getting that nice

Even at Their Worst, Bonds Play a Role

Gain Needed to Recover

Bond Returns Bond MCL

Loss

100% Stocks (2008)

-51.0% 104.0% — — -32.7% 48.7% -5.4% -12.3% -32.4% 48.0% -4.7% -4.7% -31.7% 46.5% -2.9% -6.5% -31.2% 45.4% -1.6% -4.3%

60% Stocks + 40% GNMA (1980)

60% Stocks + 40% Interm.-Term Treasury (1999) 60% Stocks + 40% Interm.-Term Treasury (1994) 60% Stocks + 40% Interm.-Term Treasury (2013) 60% Stocks + 40% Interm.-Term Treasury (2008)

-24.9% 33.2% 14.1% -3.4% Note: Table shows hypothetical returns pairing 500 Index’s 16-month financial crisis loss with the worst 16-month periods for Intermediate-Term Treasury and GNMA.

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