The View from Vanguard's Bond Guru


By Robert Barker With any threat posed by Saddam Hussein fast receding in Iraq, is the bull run in that ultimate haven, the U.S. Treasury bond, coming to an end? For an answer, I spoke recently with the chief of Vanguard Group's fixed-income operation, Ian MacKinnon. He oversees $225 billion in assets and, after 21 years with Vanguard, is set to retire soon. Before he got away, I reached MacKinnon by phone for his thoughts on the current and future bond market. Here are excerpts of our chat:

Q: Many advisers now say bonds are overpriced. Are they right?

A: They're right. Prices have been pushed probably higher than they ought to be because of the uncertainty about the situation in Iraq and the geopolitical scene.

Q: With a good conclusion to the war, do you think there will be a quick snap-down in the Treasury bond market, or is this something that would more likely evolve over a longer period of time?

A: There would be an initial sell-off of Treasuries. Longer-term, the resolution of the conflict in the Middle East would be stimulative for both the real economy and for the stock market. So I would guess that there would be some asset allocation out of bonds and into equities, and inflationary pressures would get a little bit worse.

Q: What does that imply about the market for Treasury Inflation-Indexed Securities, better known as TIPS?

A: TIPS would be the preferred ultra-safe investment under these conditions.... If real interest rates decline, you could get the price of the TIPS going up and the inflation protection on the TIPS providing a cushion in the event of the general level of prices going up. I think they're definitely a reasonable investment at this time.

Q: Are municipals in particular danger now?

A: State and local governments are undergoing rather severe fiscal stress because they've spent the increased revenues that occurred during the bubble years of the '90s without providing for controls on their spending. So they're all facing rather severe budget shortfalls as the economy has slowed down. Once they're through that, however, I think they represent pretty good value vis-a-vis taxable securities. In fact, you can get municipals today at rates that are almost equal to those of Treasuries.

Q: What about credit risk?

A: While munis may be under stress, I don't think that they're going to default on their debt.

Q: High-yield, or "junk"-bond prices have been rising. Is this as good as it'll get?

A: I don't have a strong opinion about the high-yield area. I do know that the high-yield area has been flooded with fallen angels. And so a lot of the weakness and strength in the high-yield market is driven by the technical factors of supply and demand, where the supply isn't just based on new issuance but on the supply that's created when Standard & Poor's and Moody's, among others, downgrade securities. So to determine whether there's value in the high-yield market, you need to predict accurately whether that phase of the ratings cycle has run its course.

Q: Not easy.

A: If there are a whole lot of accounting revelations still out there, like Ahold (AHO) or HealthSouth (HRC), you're going to create a lot of high-yield supply that may be difficult to digest.

Q: Should individuals spend much time varying their bond portfolios by credit quality or maturity?

A: I don't think individual investors are in a position to fine-tune with any success their fundamental mix. They ought to spend some time in the beginning getting comfortable with what they're going to invest in. Having done that, they ought to leave it to the portfolio managers.

Q: Can anyone, amateur or pro, forecast interest rates accurately?

A: Well, it's possible, but it's not possible all the time. I may sound like I'm waffling, but I'm really not. In general, market timing and trying to predict the direction of interest rates and the magnitude of change in interest rates is extraordinarily difficult to do. But I do think it's possible at times.

Q: Parting advice for individuals?

A: Caveat emptor is very much a byword given the financial shenanigans that continue to be exposed in the media, not the least of which [is] your publication. But I would also say caveat vendor. The issuers of corporate debt need to understand that with all of these shenanigans, they're eroding the foundation of trust and creditability that underpins a viable capital market.

Q: Have you found yourself shaking your head in disbelief over the news?

A: Yes. I'm almost continually appalled at not so much the frequency but the magnitude of these major corporations' restatement of financials. They create a mistrust that's built into the level of [interest rates paid by] even honest companies.

Q: Discouraging, huh?

A: Yes, it's demoralizing. Barker covers personal finance in his Barker Portfolio column for BusinessWeek. His barker.online column appears every Friday, only on BusinessWeek Online


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