(PUB) Investing 2015

Combining mortgage-backed secu- rities from Fannie Mae (FNMA) and Freddie Mac (FHLMC) as well as GNMAs, the Barclays U.S. Mortgage Backed Securities index that Mortgage- Backed Securities ETF is designed to track is wider-ranging compared to the mandate of its actively managed sib- ling. The fund holds nearly 500 bonds. How about GNMA? Michael Garrett holds just 35 bonds. This narrower focus hasn’t held back Garrett versus his in-house index compe- tition. Since the ETF began operations in November 2009, GNMA outperformed 21.9% to 18.7%. We can take this back further, as the performance history for Mortgage-Backed Security ETF’s index stretches to 1991. Again, GNMA out- performed, and this is before applying any kind of operating expense headwind to the 18 years or so of the index’s returns prior to the ETF’s launch. With a yield of only 1.52%, the ETF is well behind GNMA’s 2.22% yield. That’s another reason why I give the nod to the active fund. High-Yield Corporate Buy. High-Yield Corporate is a “junk bond” fund and as such is a very differ- ent animal from all of Vanguard’s other bond funds. The bonds in this fund are issued by companies with less-than-stellar credit ratings. To attract investors, they must offer higher yields, since the pros- pect of default is higher. And when it comes to yield, what a difference a year can make. In June 2014, High-Yield Corporate’s yield reached a record- low 3.85%—not exactly living up to its “high yield” name. But with falling oil prices putting pressure on energy companies, which tend to be big issuers of junk debt, yields in the high-yield market have risen as investors, trying to avoid troubles in one sector, sold across the entire high-yield market. High-Yield Corporate’s current 5.60% yield is looking a lot nicer today, and means we are picking up 4.16% (or 416 basis points) over Intermediate- Term Treasury’s 1.44% yield and 283 basis points over Intermediate-Term Investment-Grade’s 2.77% yield.

Importantly, High-Yield Corporate kicks off additional income without tak- ing on more interest rate risk compared to its higher-quality intermediate-term siblings. Remember, as we discussed last month, junk bonds move more in line with the economy than with inter- est rates. A growing economy makes it easier for less financially stable compa- nies to pay back their debts. High-Yield Corporate isn’t the screaming buy it was we bought the fund for the Model Portfolios in September 2011, but I continue to see good relative value in this holding. Extended DurationTreasury ETF Sell. Buckle up! When a bond fund can gain or lose more than 20% in a month, you know it’s volatile. Extended Duration Treasury ETF has already had four months in its relatively short life when it moved 20% or more. The fund’s duration of 24.7 years is much longer than its long-term siblings. Yes, you could buy this fund to bet on lower interest rates or sell it if you think rates are headed higher (and I suspect many traders do just that). But, simply put, this fund is just too volatile for investors, and hence Vanguard doesn’t even offer it in a low-minimum, open-end fund format. You have to buy the ETF to play this game. (Institutions with at least $5 million can, however, buy Vanguard’s institutional open-end fund if they like.) But why would you want to? Total International Bond Index Hold. After years of resisting and several delays, Vanguard succumbed to indus- try and customer pressure and brought an international bond fund to market in May 2013. For all its initial hemming and hawing, Vanguard itself has now gone whole-hog into this fund, carving out 30% of the bond allocation in its funds-of-funds and 529 plans for Total International Bond . The fund tracks a mouthful of a benchmark, the Barclays Global Aggregate ex-U.S. Dollar Float- Adjusted RIC Capped Index (Hedged), which covers around 8,000 investment- grade securities across the globe. As you can see in the table on page 5,

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Mortgage Association (or GNMA) is a government entity, so its mortgage- backed bonds carry an explicit guaran- tee from the U.S. Government—like a Treasury bond. Fannie Mae (FNMA) and Freddie Mac (FHLMC) are gov- ernment-sponsored entities that also create and sell mortgage-backed bonds. Because of their quasi-relationship with the government, many investors view their securities as being backed by a government guarantee, though the assurance is not as strong as with GNMAs. Mortgage-backed bonds, however, are subject to what’s called “prepay- ment risk,” which is an exaggerated form of reinvestment risk. Remember that reinvestment risk, as we discussed in the August issue, is the possibility that just as your bond is maturing and you have all your principal to reinvest in a new bond, the options available are paying lower yields. Well, prepayment risk derives from the ability of borrowers to repay their mortgages early. If interest rates fall, homeowners may refinance, and when that happens, the mortgage underly- ing a portion of the GNMA bond dis- appears, as the principal is returned. So when interest rates fall, investors in GNMAs typically begin receiving prepayments, which they then have to reinvest at lower yields. When inter- est rates rise, homeowners tend not to refinance, so the underlying mortgages stay put, and investors get less money back to reinvest at higher rates—a true double-edged sword that can nick you either way. Prepayment risk sounds like a tough deal for GNMA investors, and for the unaware, it certainly is a risk—and justification for GNMAs yielding more than Treasurys. Prepayment risk is just one reason I prefer the actively man- aged GNMA over Mortgage-Backed Securities ETF . GNMA manager Mike Garrett of Wellington is well aware of the aforementioned risks and focuses on bonds whose underlying mortgages are “seasoned,” or less likely to be repaid early.

12 • Fund Family Shareholder Association

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