(PUB) Investing 2015

state where you live, that income is not taxed at the state level, either. Hence, municipal bonds are also called “tax- exempt” or “tax-free” bonds. Given the vast number of states, counties, cities and towns in the U.S., it’s not surprising that the municipal bond market is very fragmented, with over 47,000 different bonds available, compared to, say, the 9,500 or so found in the Barclays U.S. Aggregate Bond Index (the index mimicked by Total Bond Market ). Tax-Exempt Bond Index , Vanguard’s first muni-bond index fund, tracks an index of more than 10,000 very high-quality bonds alone. As you might expect, there are many, many types of municipal bonds, so my description, while not compre- hensive, covers the majority of plain- vanilla municipal bonds and certainly covers the vast majority of bonds held in Vanguard’s tax-exempt bond funds. To BuyTax-Exempt Bonds or Not? Tax-free income sounds great, so why would you want to own any bonds other than munis?

First, if you are investing in a tax- deferred account, like an IRA, income from a municipal bond fund is treated the same as income from a corporate bond or Treasury fund, and you may actually do yourself a disservice by investing in a municipal bond fund here. Why? Because when you finally begin taking distributions from a traditional IRA, you will be taxed on income that, normally, would not be taxed. That makes no sense at all. Plus, historically, tax-exempt bond funds have yielded less than Treasury bond funds with similar maturities, and without the tax-exempt advantage, you wouldn’t buy the lower yield. However, since the beginning of the financial crisis in 2007, Intermediate- Term Tax-Exempt has regularly yielded more than Intermediate-Term Treasury , even before adjusting for taxes, so you could make an argument for owning municipal bond funds in your tax-exempt account today. But don’t expect this reversal of historical trends to last. Personally, I’d rather own one of Vanguard’s corporate-oriented

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projects of all shapes and sizes. For example, they may need to repair roads, expand a sewage plant or build a new school. To raise money, these “municipal- ities” issue bonds called municipal bonds. Municipal bonds come in different flavors based on how the money owed on their bonds will be paid back. Some muni bonds, called general obligation (GO) bonds, are backed by the taxing power of the state or city—some por- tion of sales and property taxes are used to pay bond holders. Other muni bonds, called revenue bonds, are backed by user fees. For instance, tolls collect- ed on highways, revenue collected for water or sewer services, or even fees at the town swimming pool may be used to pay off the debt incurred to build those facilities in the first place. But what really sets municipal bonds apart from Treasury, corporate and mortgage-backed bonds is taxes. The income generated by muni bonds is not taxed by the federal government. And if you buy a municipal bond issued by the

INTERVIEW > DONALD KILBRIDE Committed Concentration

Previously, you’ve expressed concern around central bank activ- ity. Are you still cautious today? And if so, what would make you more optimistic? You are exactly right; I’ve been cautious in large part because of the amount of liquidity in the system by virtue of what the central banks are doing globally. It’s not just a U.S. phenomenon; it’s the ECB; it’s the Bank of Japan, China—there’s just lots of [liquidity] in the system. My concern is that that is what is propping up markets right now—or at least is in some way helping to prop up markets. I am worried about how we reverse that. At some point, the central bank liquidity has to come out of the market, and it has to be replaced. So what would make me more optimistic, frankly, is if we got back toward an environment that is more normal. I think we are slowly crawling that way. But what does “staying cautious” mean in terms of constructing the Dividend Growth portfolio? It means we have slightly more names than you might normally expect. Again, this is a highly concentrated portfolio—and I think that’s the right thing to do. So we normally run somewhere in the mid-40s, and we might have a couple of extra names there. Just on the margin, that’s a little more cautious, and spreads the position sizes out a little bit more. Maybe run [the portfolio] with a little bit more cash. Not to buffer any downside, but to be in a position to be more opportunistic if

DIVIDEND GROWTH HAS LONG BEEN A FAVORITE since Don Kilbride, 49, a value manager at Wellington Management, took the fund over and built a concen- trated portfolio of battleship balance-sheet companies. The fund has served us well in the Model Portfolios since I first added it in November 2007. It has served

Don well, too, as he is invested alongside you, me and the fund’s other shareholders. Don, Jeff and I recently spoke about the portfolio, the state of the world’s markets, oil and what works in investing. Listen in… How is your strategy of looking for growing streams of dividends playing out in the current low interest-rate and slow-growth economic environment? The same, at least among the companies we own and the ones that we are interested in. That’s not an extensively long list of companies. We have a narrow universe. There is certainly a powerful ability among the companies that we are looking at, and the willingness is still pretty strong. Right now, balance sheets are extremely strong across the fund with almost no exceptions. Checking the balance sheet is part of my formula, as that is what leads to a strong ability to grow dividends.

4 • Fund Family Shareholder Association

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