(PUB) Investing 2015

BOND ETFS Yield’s Gravitational Pull

AS WITH ALL THINGS, but in particu- lar when it comes to investing, having options is a good thing, but having too many choices can lead to paralysis. For investors this can mean delaying a decision, and possibly failing to act altogether. Consider your choices among Vanguard’s bond index funds. For over a decade, investors got along just fine with four options: Total Bond Market and three funds of varying maturities that held both corporate and Treasury bonds. There’s nothing wrong with those “old” index funds, and they remain pretty good options to this day, but six years ago, Vanguard took a big leap in expanding investors’ options, and pos- sibly causing some a bit of “analysis paralysis” by launching seven new bond index funds and ETFs that further slice and dice the market. And two years ago, when they converted those funds’ Signal shares to Admiral shares and dropped the minimum investment hurdle, the potential for indecision mounted. With Federal Reserve Chair Janet Yellen hinting strongly that an interest rate hike is coming in December, many investors are re-evaluating their bond fund allocations, making today an ideal time to ask how those seven relatively new bond index funds have fared in the marketplace, and as viable investment choices. The answer: Some have done better than others. As you can see in the top table, the corporate bond index funds have been much more popular than their safer government bond options—all have grown to more than $1 billion in assets. Short-Term Corporate ETF and its open-end shares have been the run- away favorites. Meanwhile investors have nearly ignored the government bond indexes— Intermediate-Term Government Bond Index only passed the $1 billion mark three months ago. I thought Mortgage-Backed Securities ETF had the potential to be a big win- ner for Vanguard, and in some ways it

Investors Bought Corporate Bonds Fund

ETF Share % of AUM

ETF Share Admiral Institutional

Total $962

Short-Term Government

$648 $452 $315

$246 $420 $142

$68

67% 41% 51%

Intermediate-Term Government Long-Term Government

$229 $157

$1,101

$614

Government Subtotal

$2,676 $2,249 $2,249 $12,848 $6,743 $1,418 $21,009 $25,934

Mortgage-Backed Securities Mortgage-Backed Subtotal

$1,765

$443

$41

78%

Short-Term Corporate

$10,793 $5,946 $1,044

$1,289

$765 $343 $303

84% 88% 74%

Intermediate-Term Corporate

$455

Long-Term Corporate Corporate Subtotal

$71

TOTAL

$20,963

$3,064

$1,907

81%

Note: Values represent millions of dollars. As of 10/31/2015.

has served the firm well; $2.2 billion is nothing to scoff at, particularly con- sidering that over the past six years, investors pulled roughly $18 billion from GNMA . As I predicted six years ago, the bulk of assets invested in these funds—80% or so—has gone into their ETF shares. However, the transition from Signal shares to Admiral shares increased the availability and popularity of the open- end funds. That’s no surprise, as the Admiral shares are no more expen- sive than the ETF shares. Still, the front-end loads on the Admiral shares of Intermediate-Term Corporate Bond Index (0.25%) and Long-Term Corporate Bond Index (1.00%) will continue to lead interested investors to buy the ETF versions. Why have investors favored the cor- porate bond index funds, which hold investment-grade taxable bonds, over the government bond indexes, which invest in U.S. Treasury bonds as well as other debt guaranteed by the U.S. government or agencies? It all comes down to yield. Look at Short-Term Corporate ETF and Short-Term Government ETF . As the lower table shows, the cor- porate index fund has a slightly longer duration (more interest-rate risk), but with a yield of 1.93% versus a paltry 0.52% on the government fund at the end of October, people are choosing the higher yield. Investors face a similar

Seeking Yield

Duration (years)

SEC Yield

Fund

Short-Term Government Short-Term Corporate

1.8 0.52% 2.8 1.93% 5.2 1.39% 6.4 3.39% 17.2 2.71% 13.5 4.80% 3.9 1.63%

Intermediate-Term Government Intermediate-Term Corporate Long-Term Government Mortgage-Backed Securities Durations and SEC yields as of 10/31/15. Long-Term Corporate

trade-off—longer duration but a higher yield—when weighing the two inter- mediate-maturity funds. On the long- maturity end, one can find a higher yield and lower duration in Long-Term Corporate ETF . So far the (relatively) new bond index funds and ETFs have pulled in $24 billion or so, but it does not appear those assets have come at the expense of their older and larger sibling funds. I am sure some of the roughly $10.8 bil- lion that investors put into Short-Term Corporate ETF would have otherwise found its way into Short-Term Bond ETF or Short-Term Investment- Grade . But as those two funds actu- ally pulled in more money than the corporate index fund over the past six years—nearly $25 billion and $15 billion, respectively—it doesn’t look like investors have been dropping the old for the new, except, as I noted ear- lier, for the disparity between outflows at GNMA and inflows to Mortgage- Backed Securities ETF. However,

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