Q&A: Rates and getting income in low-yield world
Greg Davis is global head of Vanguard's Fixed Income Group, which means that he oversees the Malvern, Pa.-fund behemoth's $900 billion in bond funds. Davis spoke with John Waggoner of USA TODAY about bonds, interest rates and how to get income in a low-yield world.
Q: The yield on the 10-year Treasury note is roughly 2%. Why would anyone invest in bonds now?
A: For diversification. Regardless of where interest rates are, bonds still have diversification properties that are very important if you have an equity-heavy portfolio.
Another reason is for income. If you have specific income needs in a very low-risk type of investment.
Q: Most people think that bond yields will rise, which means bond prices will fall.
A: The question becomes whether they will rise more than has already been priced into the market. If you look at the U.S. in isolation, the number of jobs created and the lower rates of unemployment in the last couple years point to much higher interest rates. But we are in an environment with low levels of inflation. Outside the U.S., some areas are looking at potential deflation, geopolitical issues and falling oil prices.
Do we think rates will rise? Yes. If you look at the yield curve, we see that yields on the short end — inside five years — likely to rise slightly more than expected. If you go 10 years or longer, which tends to be more affected by inflation — we don't think that will be an issue. If you look at Germany, where the 10-year government bond yields 0.35%, and Japan, where the 10-year government bond yields 0.34%, our 10-year Treasury note looks very attractive to international investors.
Q: If you're not worried about inflation, are you worried about deflation?
A: In the U.S., we're not worried about deflation at all. The Fed has shown, given its policies during the financial crisis, that it's able to manage through that. In other places, deflation is more of a factor. But in Europe, the European Central Bank is implementing quantitative easing, and I don't see deflation being an issue. We see inflation as staying low, with the Federal Reserve trying to get to a 2% inflation target — we're still below that.
Q: What maturity bonds should investors favor now?
A: We'd say, be diversified across short-, intermediate- and long-term bonds. Rates are difficult to forecast. To mitigate the risk, understand your time horizons. If you're a short-term investor in a long-duration fund and rates rise, you won't have the time horizon to recoup your principal.
Q: What quality bonds should investors look for?
A: A lot of investment-grade bonds seem fairly valued to rich in here. We view asset-backed bonds, sovereign and emerging markets portion of the market to offer attractive risk-adjusted returns. And we think there's still value in municipal bonds.
Q: If you were to recommend a bond fund for a retired relative, what would it be?
A: I would say, buy a highly diversified bond fund — not just for income, but for total return. And be very, very cognizant that bond returns in general tend to be muted, and that high costs tend to erode a higher proportion of the potential return on bonds relative to stocks. When you have the 10-year Treasury note yielding 1.93%, a high-cost fund could take a third or more of the fund's returns.