(PUB) Investing 2016

to some investors, that’s not actually all that unusual. Since its December 1978 inception, High-Yield Corporate has seen 38 monthly declines of 2% or more. Four of those have been during our latest holding period. On the other hand, High-Yield Corporate has never seen consecutive calendar-year losses in its history. The 1.4% decline in 2015 was the second- smallest calendar-year loss the fund has ever suffered, and only the fifth in three decades. I recently discussed the high-yield markets with a very astute portfolio manager, who made a terrific point that the math in the high-yield bond market works particularly well in investors’ favor so long as they can think long-term. He made the observa- tion that as junk bond prices fall and yields rise, and as the yield on your junk bond fund rises, it becomes harder and harder for the fund to actually lose money in the ensuing 12 months. Think about it. At the end of 2014, High-Yield Corporate’s SEC yield was 5.04%. But the fund’s share price fell 6.7% in 2015, one of the largest declines in the fund’s history. The fund lost 1.4% (not 1.7%, because yields continued to rise over the course of the year) on a total return basis in 2015, as I said. But at the end of 2015, High-Yield Corporate’s SEC yield had risen to 6.27% from a low of 3.85% just 18 months earlier. The fund’s price will have to fall more than 6.3% during 2016, which in itself would be a huge decline, before it generates a loss on the year. It’s extremely rare to see back-to- back price declines of that magnitude.

HIGHYIELD FROM PAGE 1 >

High-Yield Annual Returns

Now, let’s look back, and then for- ward. To review, since we bought High- Yield Corporate at the end of September 2011 through the end of February 2016, our 30.0% gain nearly tripled Total Bond Market Index ’s 11.2% return. What’s happening in the high-yield (or junk bond) market right now is related to the energy sector more than anything else. With the U.S. economy fundamentally sound, there isn’t that much to be concerned with in terms of the economy sinking the prospects of most high-yield borrowers. However, there is a segment of the high-yield market that is represented by oil drillers, and in particular smaller companies in the fracking business and oil-field ser- vice sectors, which are undercapitalized. These riskier borrowers are in trouble as falling oil prices have made their wells uneconomical. It’s a given that defaults among this group of borrowers will be rising. That’s not a surprise, and it’s already priced into the market. We’ve seen a similar cycle in high yield before. In the late ’90s, the Internet was going to change the world, and so money poured into telecom and tech companies. When the boom came to an end, a lot of smaller, less-estab- lished telecom and tech companies that borrowed money in the good times weren’t able to pay back their loans. The overall high-yield bond market saw prices decline as investors sold indiscriminately, but the lasting pain of defaults was largely limited to the telecom and tech sectors.

40%

30%

20%

10%

0%

-10%

-20%

-30%

1988

1991

1994

1997

2000

2003

2006

2009

2012

2015

This time around, new drilling tech- nologies and a concerted effort to devel- op energy independence were going to change the game. Money poured into the energy sector, and loans were made that probably shouldn’t have been or at a minimum were predicated on energy prices remaining at elevated levels. Today, the overall high-yield bond market is feeling some pressure as investors shoot first and ask questions later, but one sector’s woes do not necessarily spell rolling defaults across the market—and in this case, lower oil prices may hurt the oil-service compa- nies while bolstering other companies that benefit from lower oil input prices. At the end of 2015, bonds in the energy sector represented just 9.1% of High-Yield Corporate’s portfolio. And the bulk of the fund’s assets are not invested in the junkiest portions of the junk bond market. In the realm of junk bond funds, Vanguard’s is pretty plain- vanilla and is not out reaching for the highest-yielding bonds with the junki- est credit ratings. But that doesn’t mean it can’t lose money from time to time. To give you a sense of periods when the fund has generated negative total returns, since the financial crisis, High- Yield Corporate has only seen a dozen six-month periods when returns were negative. January and February mark the end of the 13th and 14th such six-month periods. So I understand your concern if you aren’t taking a longer view. Though the fund only declined 1.0% in January and gained 0.1% in February, it was down more than 2% midway through both months. While unsettling

High Yield’s SEC Yield

High-Yield’s Portfolio Isn’t the Junkiest

14.0%

10% 12% 14% 16% 18% 20%

12.0%

10.0%

8.0%

6.0%

0% 2% 4% 6% 8%

4.0%

2.0%

0.0%

Caa3 C

B1

B2

B3

Ba1

Ba2

Ba3

U.S. Gov. Aaa

Aa1

Baa2

Baa3

Caa1

Caa2

1/09

7/09

1/10

7/10

1/11

7/11

1/12

7/12

1/13

7/13

1/14

7/14

1/15

7/15

1/16

4 • Fund Family Shareholder Association

www.adviseronline.com