Perryne Desai, CFA, is the Head of Index Fixed Income Product at Vanguard, responsible for overseeing the strategy and expansion of Vanguard’s fixed-income exchange-traded funds (ETFs) and related products. Our conversation covers fixed-income basics, different indices that funds follow, how to use bond funds and ETFs in portfolios, and the new products Vanguard has launched or is developing. For information on understanding bond math and various types of bond yields, see Bond yields 101: A guide for smarter investing.
Rick Ferri, a long-time Boglehead and investment adviser, hosts this episode. The Bogleheads are a group of like-minded individual investors who follow the general investment and business beliefs of John C. Bogle, founder and former CEO of the Vanguard Group. It is a conflict-free community where individual investors reach out and provide education, assistance, and relevant information to other investors of all experience levels at no cost. The organization supports a free forum at Bogleheads.org, and the wiki site is Bogleheads® wiki.
Since 2000, the Bogleheads have held national conferences in major cities across the country. In addition, local Chapters and foreign Chapters meet regularly, and new Chapters form periodically. All Bogleheads activities are coordinated by volunteers who contribute their time and talent.
This podcast is supported by the John C. Bogle Center for Financial Literacy, a non-profit organization approved by the IRS as a 501(c)(3) public charity on February 6, 2012. Your tax-deductible donation to the Bogle Center is appreciated.
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Transcript
00:00:11 Rick Ferri
Welcome to Bogleheads® on Investing, Episode #90. Today, our special guest is Perryne Desai, head of index fixed income products at Vanguard. We’re going to be discussing fixed income, starting with the basics, moving into their most common uses, discussing new fixed income products that Vanguard has recently developed, and then talk about the future.
Hi, everyone. My name is Rick Ferri, and I am the co-host of Bogleheads® on Investing. Jon Luskin is the other host, and we’re now switching back and forth, bringing you a greater variety of topics and guests.
This episode, as with all episodes, is brought to you by the John C. Bogle Center for Financial Literacy, a nonprofit organization that is building a world of well-informed, capable, and empowered investors. Visit the Bogle Center at boglecenter.net, where you will find a treasure trove of information, including transcripts of these podcasts.
Today, our special guest is Perryne Desai, head of index fixed income product at Vanguard. Fixed income has been difficult for many investors. During COVID, the 10-year Treasury dropped to an interest rate of about 0.5% and then shot up to 5%. Now it’s sitting around 4.25%.
This volatility in bonds caused a lot of angst among investors who lost a lot of money in fixed income during that period of time. But interest rates are higher now, and bonds are back. So I asked Perryne to join me today to go over three things.
First, the basics of fixed income investing. Second, how to use fixed income in a portfolio. And third, all the new and exciting things that Vanguard and other companies are developing that help us invest in the fixed income market.
So with no further ado, let me introduce Perryne Desai. Welcome to the Bogleheads® on Investing podcast, Perryne.
00:02:18 Perryne Desai
Thank you so much for having me.
00:02:19 Rick Ferri
The reason I wanted to invite you on is because I get so many questions about fixed income, bonds, bond funds. A lot of people are questioning whether they should have bonds in their portfolio. And so I wanted to have this podcast with you to go over, from the beginning, what are bonds, how are they created, why do they exist, what are the different types, how should they be used in portfolios, and then some of the unique things that Vanguard is doing with bonds in the last couple of years.
But before we get started, I’d like to ask you about you personally. Tell me a little about yourself, how you ended up at Vanguard, and then what your various roles are at Vanguard.
00:03:11 Perryne Desai
Sure. I would start with I spent five years on Wall Street. I started by covering fixed income on a sales and trading desk. Then I moved to equities. I was working with banks and hedge funds. It was a really interesting time. I really enjoyed the clients that I was meeting. I really enjoyed how they were thinking through how to manage their portfolios. And I said, I would love to be on the other side of the table.
So I went to business school at Stern, hoping to break into asset management. And I found Vanguard through their MBA program. So my goal in joining was to end up on the credit research team. My first rotation was in our 401(k) business.
Then I moved into our portfolio review department, where I learned how Vanguard monitors the health of our product lineup. We make changes to existing products where we think we need to, and we launch new products to better meet client needs. I fell so in love with the work. I joined, in essence, the research team on how to launch new products across all asset classes.
After a couple of years, I was able to take on a leadership role on the team. After a couple of years, we were asked to specialize by asset class, and I chose to come back all the way back to my roots in fixed income. After a few years of running that strategy team for fixed income, I was asked to lead the index function. And so the difference here is I’m now responsible for the health of the franchise and setting the strategy. So before, it was almost like product by product, and now I set the tone at the index fixed income category level.
00:04:46 Rick Ferri
Oh, so this would include things like whether investors should be seeking longer-term yields or shorter-term yields or corporate bonds versus treasuries. Is that the type of strategy we’re speaking about?
00:05:01 Perryne Desai
It’s more that do we have all of the right tools in the toolkit so that clients are able to make those decisions aligned with our investment strategy thought process.
So we have an investment strategy team. I think you interviewed, actually, Joe Davis in one of your podcasts. His team is more responsible for setting the long-term economic outlook and how that applies to the various asset classes.
My job is to make sure that we have all of the right tools so that if clients want to engage with Vanguard across the spectrum, they have all of the right index funds, whether they’re a mutual fund or ETF or even collective investment trusts.
Do they have all the right tools in the toolkit so that they can invest the way they want to so that they can reach their preferred investment outcomes?
00:05:51 Rick Ferri
So let me ask a question about that because it goes way back with myself and Vanguard having to do with international bonds. I know this is going to be a little off topic. I’ve never been a huge fan of international bonds in a portfolio, but if you’re going to do a global equity fixed income portfolio, you would use them. And Vanguard PAS uses them and uses them in various other places. Okay, but without just debating the merits or so forth of international bonds, Vanguard did create a couple of international bond funds. So what you’re basically saying is we’ll create the product, and we’re going to do a good job and do it low cost. You decide whether or not you want to use it in your portfolio.
00:06:30 Perryne Desai
I think that’s right. Our global head of fixed income, Sarah Devereaux, basically thinks about the most important thing to consider is allocation. Get it into your portfolio: active, index, mutual fund, ETF. Our job is to make sure that we have all the right tools in the toolkit for you to be able to invest into.
00:06:48 Rick Ferri
Great. Perfect. Now, we’re going to get into the guts of this discussion, and it’s going to be techy. I’ve been in the business for 40 years, and I find that equity investing is actually easier than fixed income investing. Let me explain.
I have come to the point that most people’s equity portfolio should be for money that they might need 10 years and later. And buying just a US equity index fund or ETF and an international equity index fund and ETF, or in some accounts, a global equity ETF or index fund is all you need. You don’t need anything more than that for most people.
But fixed income is more complicated. There’s more choices. There’s more things to consider. Would you agree with that?
00:07:35 Perryne Desai
Yeah, I would think so. I think fixed income is a lot more accessible than people give it credit for.
00:07:39 Rick Ferri
Let’s go ahead and get into the nitty-gritty of this. And so let’s just start with so everybody’s on the same page. Let’s talk about what a bond is and what are the basic components of a bond.
00:07:51 Perryne Desai
Sure. Bonds are, in essence, an agreement where you will give me principal upfront for a certain number of years, and I will give you back coupons and principal at the end of the life of our agreement.
It’s like a loan. Every bit of math is derived off of that basic principle. You can embed options into it with call features. You can have the principal declining over time like you would in a mortgage. But the meat and potatoes is it’s a loan.
00:08:22 Rick Ferri
Tell me what the difference is between face value and market price.
00:08:27 Perryne Desai
Sure. So face value is what did the company or you and I in a bond type agreement, in my earlier example, what did we agree to in terms of principal? How much did I loan you or how much did you loan me?
The market value is derived from what’s the right yield for that particular loan. So let me give you an example. If you and I agree that the rate on our coupon is going to be 4%, so that’s market value. When you and I structure this term, we say, “Okay, I’m going to pay you 4%,” and that’s driven by the fact that I’m an individual. I have a certain amount of credit risk associated with me. That’s the market rate for me asking you to loan me money.
00:09:13 Rick Ferri
Is that the coupon rate?
00:09:16 Perryne Desai
So that’s the coupon rate. I’m going to get you to yield. So tomorrow, you wake up, and the new going rate for a coupon issued by someone like me is now 5%. You’re upset because your bond is now worth less than what you could have otherwise gotten in the market. So what happens is the price drops, so your yield goes up. Your yield is, in essence, the price appreciation. Your market price goes back to par value at the end. It is the accrual of your discount in this case, plus the coupon.
00:09:51 Rick Ferri
Let’s say we made this deal back in 2020 when interest rates were way down, and we made this deal at 1%. So you borrowed $10,000 from me and agreed to pay me 1% interest for, say, five years. Then interest rate starts moving up rapidly. Well, no one’s going to accept a bond that has a 1% coupon where they can go out and get 5% on a new issued bond.
00:10:21 Perryne Desai
So not at par. So you are the owner of this bond, Rick. And while you are the owner of this bond, you and I might have agreed to par value when we started out, and now your value is something less than 100 cents on the dollar. I don’t know exactly what your number would be, but it’s not going to be 100, right? Because it’s not fair that somebody else has to take on your bond with a 1% coupon when the market is yielding 5%. So in essence, your price will drop until your yield becomes about 5% for a similar bond in that market.
00:10:57 Rick Ferri
Because nobody’s going to buy that 1% bond unless the yield to them or the total return to them is going to be 5%. They can get that in the open market with a new issue.
00:11:06 Perryne Desai
Is equivalent.
00:11:06 Rick Ferri
That’s why bonds and bond funds lost money coming out of COVID when interest rates jumped.
00:11:11 Perryne Desai
That’s exactly right.
00:11:12 Rick Ferri
So in the public markets, when these bonds are issued, all of this is spelled out in a document called a bond indenture. Could you explain a little bit about that?
00:11:23 Perryne Desai
Just like a stock has a prospectus, a bond will have all of the terms and conditions listed out on one sheet.
00:11:31 Rick Ferri
If there was a default, then that’s also part of the debenture. It tells you what happens to the bond if there’s a default.
00:11:38 Perryne Desai
That’s right. It’s interesting, right? Let me actually take a big step back. When we think about companies issuing bonds versus issuing equities, take a look at Apple as an example. Apple is one stock. I looked on Bloomberg this morning. There were more than 30 bonds associated with Apple.
And each one has a different coupon. It’s got a different term structure. It also sits differently in terms of who gets money if Apple all of a sudden defaulted. So you have more senior bonds. You have subordinated bonds. You have bonds that are tied to various equipment.
You have so many parts of that organization that it takes a lot of work to pick the right bond, whether you are an index or an active. I’m going to make a short plug for my team for a second. When you have a great credit research team or you have a great asset manager, the role of our portfolio managers is to pick the right versions of those bonds that meet their criteria, whether it is total return, hitting a certain yield target, or maybe an Apple. It’s getting the exposure to Apple. It’s getting the exposure to the part of the curve that they want to be in and maybe doing some relative value relative in thinking through, should I buy this Apple coupon or that Apple coupon or this Apple coupon versus this Google coupon bond instead?
00:13:04 Rick Ferri
I want to get into the various types of bonds which have been included in a total bond market. This is a taxable fund and then parsed out into corporate bonds, government bonds, various types of government bonds. So could you describe the public markets out there and what is available to people?
00:13:26 Perryne Desai
Yeah, absolutely. So let’s stay in US taxable because even that is pretty broad. Let’s start with the big sub-asset classes. You have treasury bonds that are issued by the US government. You’ve got mortgages. You’ve got corporate bonds. You’ve got inflation-protected securities. You’ve got high yield.
So the aggregate bond index is comprised of everything that I just mentioned except for inflation-protected securities and high yield. The aggregate index, which is what total bond tracks, began life in the 1970s before things like the inflation-protected securities market really came to the fore, before high yield became indexable or even EM.
I would say the aggregate bond index is a really diverse, really complex market. So when you look at our total stock market ETF VTI, there are about 4,000-ish stocks in the portfolio where there are 13,000-ish in BND. So their complexity sort of grows as you include various asset classes.
00:14:32 Rick Ferri
If people want to better understand where the aggregate bond index came from and Vanguard’s role in creating a total bond market index fund and the history of that because it wasn’t even allowed to be called an index fund when it first came out.
I did a podcast with Nick Genron, the global head of fixed income product management at Bloomberg, which is the index side of the aggregate bond, and Josh Barakman, the principal and senior portfolio manager and head of fixed income indexing in America on the Vanguard side as to how they track that index. And it was an interesting podcast. That was Podcast #45.
00:15:19 Perryne Desai
Oh, that’s cool. I have to go back and find it.
00:15:21 Rick Ferri
Yeah, it was really an interesting podcast. It really was because they talked all about should we include TIPS, should we not include TIPS, why should we include them, which is what the index provider wanted to do, why they weren’t included, which is what the licensees of the index wanted. So it was really interesting to see the development of that index and how it’s changed over time.
Anyway, so let’s now move to the tax-exempt side of the bond market, which would be municipal bonds.
00:15:56 Perryne Desai
Sure. Municipal bonds are really interesting. It’s about a $4 trillion market today. Muni bonds are issued by state, city, and local governments. They are generally exempt from federal taxes and can also be exempt from state and local taxes, assuming you live in that state or locality. So that’s the benefit in and of itself. Taxes and fixed income distributions are often taxed at ordinary income. Those taxes start to matter, particularly as you climb up that marginal tax rate ladder. I am not a tax expert. We’ll start to push the bounds of my abilities here pretty quickly, Rick.
00:16:37 Rick Ferri
Okay, fair enough.
00:16:38 Perryne Desai
What I would say is muni bonds are really great for a lot of investors. It’s not just for people who are at that top marginal tax bracket.
00:16:47 Rick Ferri
Agreed.
00:16:48 Perryne Desai
The yield curve on municipals is so much steeper than the yield curve on treasuries that you actually benefit from investing in municipal bonds as you go out on the curve. So as you take on duration, you benefit even at lower tax rates because the marginal tax-exempt yield that you are earning is so much higher than what you would earn otherwise for similar sort of credit risk.
00:17:14 Rick Ferri
You know, we’re going to get into the risks in a second, but that has been so true as I look at various maturities of municipal bonds, noticing that the yield curve has maintained its steepness in the muni market, whereas in other markets it did not. But getting into these technical terms, I do want to start talking about the risks of all bonds. There’s a lot of different terminology out there, and it’s going to take a little bit to explain it. Interest rate risk, which is also term risk, inflation risk, credit risk, prepayment risk called call risk. So explain all these different risks that are in the fixed income market in general.
00:17:56 Perryne Desai
Sure. I would probably give you three primary risks. The first is that of interest rate risk, and you can measure that using duration. That’s a term that you will hear often when thinking about fixed income. It basically tells you how sensitive your bond is to a given change in interest rates. The larger the duration, the more sensitive your bond is. Think about our earlier example of lending each other money. If you’re lending to someone for 10 years versus three years, there’s a pretty good chance you’re taking on greater risk. So duration is a measure of that interest rate sensitivity.
00:18:32 Rick Ferri
So that’s a good explanation of duration. Thank you. But I have a question about duration, and it is sometimes people say things like duration will tell you how much percentage-wise a bond will move up and down in price based upon a 1% move in interest rate.
00:18:56 Perryne Desai
That’s right.
00:18:57 Rick Ferri
Given a five-year bond, if it has a duration of three years and interest rates move up to 6% from 5%, I should expect the market value of my bond to fall by about 3% because the duration is three years. Is that fairly accurate?
00:19:18 Perryne Desai
Yeah, that’s fairly accurate.
00:19:20 Rick Ferri
There’s another term out there that people hear once in a while, and it’s called convexity.
00:19:25 Perryne Desai
Yep. I’m going to back us up just a little bit because call risk helps you think about convexity. So call risk occurs when you have options embedded in your bonds. Most often we see that in mortgages and munis. So convexity starts to show up because it measures the sensitivity of being in the money or out of the money on that call option.
So think about a mortgage. If you’ve locked in, say, a 5% mortgage on your house and all of a sudden 30-year rates drop to 3% again, I’d want to refinance that mortgage and take out a 3% one instead. Hopefully, other people would too. And then in aggregate, as mortgages do this, these bonds become more sensitive than their duration would suggest to interest rates. So convexity is sort of your extra sensitivity to being in or out of the money on the call option that you actually have as a homeowner on your mortgage.
00:20:19 Rick Ferri
Sometimes those options don’t seem to be accurately priced to me, meaning there seems to be a whole lot more risk in buying somebody else’s mortgage at 6%, knowing that they can refinance and call in their loan anytime they want. I should get paid a heck of a lot of money for that, but it doesn’t seem like I’m always getting paid enough for that risk. What do you think about that?
00:20:51 Perryne Desai
I think this is a great opportunity to have a really strong asset manager on your side, Rick.
00:20:57 Rick Ferri
Okay. Good answer. All right, fair enough.
00:21:02 Perryne Desai
I’ve gotten a chance to sit with both our active and indexed sides. We have an active rates team. They focus very heavily on mortgages. We have indexed products like VMBS. Mortgages show up all throughout our lineup. And what is really interesting is how people think through prepayment risk, that risk of you calling the mortgage faster than I would anticipate. Maybe I pay too much for that bond.
So they go deep into really trying to understand the locality of the mortgages that underpin our mortgage bonds. They go deep on trying to understand the tranches of the various sort of rates and durations of those structures. They go deep on trying to understand how the mortgage industry operates. So they’ll look at the housing market. They’ll look at the various movements of various housing markets across the country, and they will roll that up into how we think about each and every mortgage bond in our portfolio.
When I was in fixed income in my first job out of college, I was learning about prepayment tables. And there’s this company out there, I’m sure they still exist, called Andrew Davidson. And they were like the preeminent prepayment calculator. So they had all these prepayment rates by 15-year, 30-year, various states, etc. And I wanted to learn more about mortgages. I walked down to their offices in SoHo one day. It was hot. It was sweaty. And I picked up perhaps one of the few copies that they allowed to be published because you can only get it at their office and learned prepayment tables the old school way. I admit that is a long time ago, and most of that knowledge is lost, but I still have the workbook somewhere at home.
00:23:03 Rick Ferri
Let’s talk about municipal bond prepayment risk because Vanguard has few municipal bond funds that are longer term. And the high-yield municipal bond fund has a fairly long duration. But I used to manage municipal bond portfolios, and almost every municipal bond offering by a municipality that has maturities more than 10 years has a call feature.
When we’re looking at something like a yield to maturity of the portfolio, which you can find on a Vanguard website, you look at any of the bond funds and you go down to the characteristics, and it’ll say yield to maturity, which I’m going to get into in a minute about the difference between that and SEC yield. And when there’s a call feature on a bond, there’s a different kind of a yield called yield to worst, which is different than yield to maturity. How do I use that?
00:23:59 Perryne Desai
What I like to use when thinking about any kind of bond is the yield to worst. There are three sort of yield to somethings out in the market. There’s a yield to call. There’s a yield to maturity. And there’s a yield to worst. Generally speaking, the yield to worst, it’ll take into account the option value that exists within your bonds.
00:24:20 Rick Ferri
Option meaning call feature.
00:24:21 Perryne Desai
The call option. Right. So it’ll either show you the yield to maturity or the yield to call, depending on the current value of your call. So it’s sort of like your worst-case scenario.
00:24:32 Rick Ferri
Is yield to call and yield to worst the same thing?
00:24:34 Perryne Desai
Not necessarily. If your option is out of money, so the bond will not be called, then your yield to worst will actually show you your yield to maturity.
00:24:43 Rick Ferri
Oh, I see. As a bond investor, what is SEC yield? And should I be using that when I’m trying to figure out what my expected return is on this bond fund? Or should I be using yield to maturity or yield to worst if that’s what’s showing up?
00:25:02 Perryne Desai
We have a great article on our website. I can give it to you for your show notes.
00:25:06 Rick Ferri
Sure. I’ll add a link in the note.
00:25:08 Perryne Desai
The simple explanation I would have is the SEC yield is a standardized calculation. So it’s a good way to compare apples to apples yields across various providers.
When I think about, if I look at Vanguard’s lineup, I like to use the yield to worst in thinking about my total return because it’ll help me think through sort of the long term. If I were to hold these bonds to their worst option, whether it is a call or maturity, what am I likely to receive by holding these to maturity or to call?
00:25:44 Rick Ferri
So I agree with you, by the way. And I often talk with clients when I’m looking on a particular bond. The clients will sometimes come to me and say, “The SEC yield is 4% on a fund. 10-year treasury at the time might be 5.” And I say to them, “Well, that’s because the coupons within the bonds that are being held in the portfolio have lower coupons because the bonds were bought during this period of time when interest rates were low.” So the SEC yield, which is simply the cash flow coming off of the fund, is only 4%. But if you want to get an idea of what you should earn from the portfolio, you have to go further down on the website to the characteristics of the portfolio. And there you’ll find yield to maturity, which I believe Vanguard uses yield to worst.
00:26:36 Perryne Desai
We do.
00:26:36 Rick Ferri
Right. So go down to the bottom and you look at yield to maturity. That’s going to give you a better indicator and also even a better kind of apples to apples comparison to other bond funds of what you should expect as a rate of return. That SEC yield, depending on how volatile interest rates are and whether we have a big move up or a big move down, can be misleading.
00:26:56 Perryne Desai
I think misleading is difficult to say about a regulated yield.
00:27:02 Rick Ferri
I got you. Let me reword it. Kind of gather the wrong information if you’re trying to do a comparison, I think, of what your expected return will be if you’re using SEC yield. I think it’s better to use yield to maturity.
00:27:15 Perryne Desai
Yeah. That’s why I think if you’re comparing two products like us versus one of our competitors and you want to understand what is the product currently yielding right now, the SEC yield is a good way to compare apples to apples within a certain category. As you then start to expand, how should I actually think about this product and what should I as a shareholder of this product receive? That’s why I like yield to worst.
00:27:43 Rick Ferri
Let’s talk about another thing called current yield. And let me tell you a story. So I was in the brokerage industry back in the late 1980s, early 1990s. And I was talking with the client and a bond that I was showing this client. It was a municipal bond. I said to the client, “This municipal bond has a yield to maturity of 4%.”
And he said, “Let me think about it.” He calls me back like an hour later. He goes, “You know, I talked to my other broker and I can get that exact same bond with a current yield of 5%.” I said, “Well, hold on now. We’re talking about two completely different things between yield maturity and current yield.”
So explain what current yield is.
00:28:31 Perryne Desai
Current yield tells you the return you could expect if you bought the bond and held it for a year. But it doesn’t reflect the actual return you’d receive until the bond, if you had held the bond to maturity, say. So it’s really only a one-year look.
00:28:46 Rick Ferri
So if the bond had a high coupon, but because it had a high coupon, it was returning capital to you, you’re paying a premium for that bond. So when it matures, you’re only going to get par value. So you’re going to lose money in the end.
I don’t mean lose money. If you bought the bond at 110, it’s going to mature at 100. So you’ve got this decline in market value that’s going to occur between the time you bought it and the time it matures. So that is a loss.
00:29:15 Perryne Desai
Correct.
00:29:16 Rick Ferri
But it’s this combination of higher coupon plus gradual loss in market value to get to par to maturity that gives you your total return. But that extra $10 loss at the end is not computed in current yield. So in my scenario, that other broker was being dishonest. So therefore, the current yield is overstating or understating what the expected return or the horizon yield, again, another yield out there, is going to be of the fund.
00:29:51 Perryne Desai
I think that’s fair. I would probably say when you are buying that high coupon bond, you are buying it at a premium. And so what you’re in essence doing with that premium is you’re amortizing it down just like a car. You would amortize that over time or equipment down to its par value at the end of its life because that’s what you’re going to receive at the end.
So when you are amortizing a premium, that’s sort of a negative number relative to your coupon. When you are amortizing a discount or accruing a discount up to par, that’s additive to your yield. So again, it all comes back to that bond math.
00:30:25 Rick Ferri
It all works out to a yield to maturity or yield to worst. So that’s what I think people should use to determine expected long-term return from a bond fund. I’m going to switch gears in here again. Let’s talk about credit risk. So can you describe what credit risk is?
00:30:44 Perryne Desai
Credit risk is basically thinking about the likelihood of default, right? Are we ever concerned that a company or government can’t pay its debt? What I really like about municipalities is they generally speaking have higher credit ratings than other sub-asset classes and have historically fewer defaults.
00:31:05 Rick Ferri
That’s very interesting, by the way. I noticed that it’s like one quarter the number of defaults for the same credit rating as, say, corporate bonds. So it’s different. But go ahead. I mean to jump in.
00:31:20 Perryne Desai
Yeah, it’s different because a corporation, there’s only so much debt they can take on before their capital structure starts to look pretty scary.
Whereas municipalities have levers like raising taxes on their population that gives them the ability to service their debts. They also have guarantors at certain levels, right?
Where I live in the great Commonwealth of Pennsylvania, my municipality might have an opportunity where the state might step in if my municipality goes bust or issues too much credit, too much debt. So there are, in essence, backstop obligors for certain municipalities that make them less prone to that default risk.
00:32:05 Rick Ferri
Well, the interesting thing about municipals is that a city cannot go out of business and just dry up and go away like a corporation can. I mean, you still have to have schools. You still have to have water. You still have to have utilities. You still have to have roads. So it just can’t go away. Counties bail out cities. States bail out counties. Federal governments bail out states. Even though it’s comparable in an A-rated corporate to an A-rated muni. In my own view, I always looked at the A-rated muni as being a better credit rating from the sense that it has less chance to default than the A-rated corporate because the A-rated corporate, that can just go away.
00:32:46 Perryne Desai
That’s an interesting point, Rick. I haven’t necessarily thought about it in that way. A credit rating is designed to take all of that into consideration. But I would say, generally speaking, municipals skew toward higher quality where corporates have more of that longer tail distribution toward the higher yield part of that credit.
00:33:09 Rick Ferri
One more thing before we go into how do you use bonds in a portfolio. And that is, what’s the difference between a cash equivalent, a note, and a bond?
00:33:20 Perryne Desai
It’s all about sort of its maturity profile. So a cash equivalent will be a relatively short-term bond. Notes and bonds tend to be more in treasury land. So notes tend to be the shorter end of the curve. Bonds are longer end of the curve.
00:33:35 Rick Ferri
One year or less, it’s a cash equivalent. If it’s between one year and 10 years, it’s a note. And if it’s over 10 years, it’s a bond. And that’s sort of what I learned. And I don’t know where. I believe you’re right. It’s treasury land.
Now let’s go into uses of bonds. There are many different uses for bonds. Why don’t you describe in your own words what you see the uses for fixed income? Let’s just not call it bonds because mortgages are not bonds, but they’re fixed income. So uses of fixed income.
Because again, and here is a period of time when the stock market has just done fabulous. And I’m getting a lot of questions about should I even have any bonds in my portfolio? So I’d like to hear your views on this.
00:34:21 Perryne Desai
Sure. Happy to. I think about fixed income playing two primary roles. First, it acts as a ballast against equity market volatility. So it’s a great pairing for clients who want to protect against that downside risk of your equity markets. One of the ways it plays that role is having a different return pattern than equities. So in essence, lower correlation creates times when the equity market goes down, perhaps the fixed income portion of your portfolio remains stable.
00:34:50 Rick Ferri
I want to stop you for a second. You said perhaps, perhaps.
00:34:54 Perryne Desai
Not always true. Not always true. We’ve certainly seen that in recent memory. But more often than not, having that protection provides downside protection risk. So if you are a retiree, you are living off of your portfolio. Having a portion of your assets in fixed income will more often than not help protect you from that downside risk in equities and make sure that your drawdown overall does not impact the way that you live your life.
The way it creates that lower correlation is having exposures that are different than the equities market. So when you think about the equities market, it’s all corporations that have gone public. Whereas the fixed income market, as we just talked about, is a lot more varied. That is the first sort of section that I would talk about.
The second role it plays in a portfolio is income generation. So I recognize, again, we’ve hit a period where we have lived through extremely low interest rates and then quite a big jump in interest rates. It still holds, particularly now that while investors are aging and they need income to replace your wages because you want to retire and go live on a beach somewhere, or maybe that’s just me, you want something to be able to replace that wage. You need something to replace your income. We now have income back in focus because yields have risen. So even though rates are starting to come down, right, and the Fed is starting to cut those rates or has been cutting rates for some time, you’ve still got a meaningful coupon, which means that you have a meaningful yield.
00:36:34 Rick Ferri
You’ve given us two. I’m going to give a third. So you’ve given us it’s not equity, meaning it’s a different return path, usually. The second thing is income generation for, like you said, retirees. But I’m going to give you a third one. And it’s called liability matching. It’s simply, I know I have a liability out there.
Let’s say I’m going to buy a vacation home in five years. And I want to have the money or I have the money available to do it now. But I want to make sure I absolutely have the money available five years to buy that vacation home. So instead of putting it into equity, I put it into a fixed income product where I know what the value is going to be. In other words, I match my personal liabilities to my portfolio. So if I have shorter-term liabilities, I buy shorter-term bonds or shorter-term bond funds. And if I have longer-term liabilities, I buy longer-term bond funds.
And I often tell people who are retiring that probably a 10-year bond allocation to your spending is not a bad idea when you’re retiring. Because if you get a downdraft in the equity market, you know a lot of people don’t like to sell equity when the market’s down. So you have this 10 years’ worth of fixed income in your portfolio when you retire where you could draw down on the bond side during that period of time. So that would be my third one.
00:37:51 Perryne Desai
Yeah. I mean, look, I love liability matchings. Many of the clients that I’ve spoken to are saying, “I want to put this money to work so that it’ll come back to me when my kid’s tuition is due for college.” Or, “I want to be able to put a down payment on a house.”
Recently, and I’m really excited about this, we’ve announced that we will launch corporate target maturity ETFs. The A filing just came out. So we’re hoping to launch in late Q1. But these are ETFs that can act as a liability matching tool for investors.
00:38:25 Rick Ferri
Well, you stole my thunder there.
00:38:27 Perryne Desai
Oh, no.
00:38:29 Rick Ferri
That was my next question.
00:38:31 Perryne Desai
You can just dub right over me. Just delete it.
00:38:35 Rick Ferri
That’s exactly right. A lot of people use zero-coupon bonds or had been using zero-coupon bonds where they know that at a particular time when the bond matures, you’re going to have exactly the par value. Bought a five-year zero-coupon bond and you paid $75,000 for it. But there’s no coupon paid. Five years down the road, it’s going to be worth, let’s say, $100,000. You know exactly what it’s going to be.
00:39:02 Perryne Desai
Right.
00:39:03 Rick Ferri
Now the fixed income market, the products out there have gotten even a little bit more interesting than that. And because you could be using corporate bonds in these new target maturity funds that do the same thing. They mature on a certain date. But because they’re not all treasuries, you’re able to pick up a little bit better yield. Is that how it works?
00:39:24 Perryne Desai
That’s right. That’s how it works. So a lot of our clients in the past, they don’t just use treasuries. They use municipal bonds. They use corporate bonds. And when you are investing in an individual bond and you’re creating this liability matching program for yourself, it can be sometimes disadvantageous because you don’t have the diversification. You are taking on a ton of risk associated with those individual names in your portfolio, maybe not the treasury, but in corporates and munis.
And so the corporate target maturity ETF is designed to give you as much of that almost bond-like performance in that it will mature at the end of its life cycle. So if you’re investing in a 2030 target maturity ETF, it will liquidate in 2030. But you’re getting the exposure to all of the corporate bond universe that is going to be maturing in 2030. So you have broader diversification. You actually can increase your yields. And you have the ability to do it at a low cost. So when clients are doing this with individual corporate bonds today, that’s really hard to get right from a transaction cost perspective. You’re paying through the nose for spreads because you’re trading in small size.
00:40:47 Rick Ferri
Yes. Always a problem.
00:40:48 Perryne Desai
Always a problem.
00:40:49 Rick Ferri
Maybe not so much with treasuries, but corporates and municipals, the spreads on those can be quite large.
00:40:55 Perryne Desai
That’s right. But here in an ETF wrapper, you’re getting the broad diversification. You’re getting access to all of this with an ETF-like spread.
00:41:05 Rick Ferri
Let me ask a question about your offerings. Are they just corporate or are you doing municipals also?
00:41:13 Perryne Desai
For now, it is just a corporate suite. We’re keeping an eye on municipals. As we think about Vanguard product development, do you mind if I go on a tangent, Rick?
00:41:24 Rick Ferri
That was really the idea for my question indirectly. It’s for you to go ahead and go off on this last thing called the future, which is simply, where are you going with all this? Yeah.
00:41:34 Perryne Desai
Well, so I actually, I would anchor you to Vanguard’s product design principles. These are the principles by which Vanguard launches any product globally. They are designed in four ways. And they’re always thinking about how we can best serve clients, meet their investment needs, and set them up for investment success, right?
We start with the investment case. Is this investment, is this product that we’re trying to launch going to be designed effectively with an economic rationale and broad diversification?
Then we have the client case. The client case is really designed to help us think about, are our clients going to be well served by having this product? How are clients going to use this in a portfolio? How are they going to invest over time in these? And are we best meeting our clients’ needs?
The third is the business case. Can we come in and offer a Vanguard-style product? Can we do it at a low cost? Can we gain scale effectively? Can we offer a differentiated service to investors by offering this product?
And finally, it’s feasibility. It’s like, can we do it operationally? Do we have all the right people in place? Legally and regulatorily, is there anything that we need to think about?
Those are our product design principles. And so every time we look at a product and our senior staff reviews our product designs, they are thinking about those four principles. So I love the idea of a municipal target maturity ETF lineup. Do I have one yet? No. Because we’re thinking through all of those things and all of those issues.
00:43:13 Rick Ferri
Couple of other questions here on product. I’ve never been adverse to people putting some corporate high-yield bonds in their portfolio. And I always loved the Vanguard corporate high-yield bond fund. But it’s an actively managed fund that really does a great job when you look backwards. It’s been around for a long time. But that’s it. That’s all you have. That one fund. I mean, there’s no index fund. There’s no ETF.
00:43:41 Perryne Desai
Well, actually, we do have an ETF. We just launched VGHY last year.
00:43:45 Rick Ferri
Oh, well, tell me about that.
00:43:48 Perryne Desai
Absolutely. It is fully managed by our Vanguard fixed income team. The portfolio manager is Mike Chang. Frankly, we launched the ETFs because you see the rise of ETFs. You see the rise of active ETFs. There are now more active ETF products than there are index ETF products. And we recognize that clients want to be served in a whole bunch of different ways by Vanguard and our peers. They want an active ETF and a mutual fund and an index fund. They want the ability to choose their manager. They want the ability to choose their wrapper. And so we want to come and offer broad access to best-in-class portfolio managers, asset classes, and performance. And so we launched VGHY last year to be able to do all of those things.
00:44:34 Rick Ferri
And I’m looking at that now. Just looking at it. Same expense ratio, fixed income characteristics. A lot more bonds in the regular high-yield bond fund than the ETF. Maturity and duration look fairly similar. So fairly comparable to the existing Vanguard high-yield corporate bond fund.
00:45:02 Perryne Desai
Yeah. I would say there’s probably two key characteristics I would call out. One is the existing Vanguard fund has been around for a much longer and was managed by Wellington solely for quite a number of years. I would say the multi-manager design structure is different than the ETF, which is solely managed by our fixed income team here. We expect to have more bonds in a much longer-tenured fund than we would in the ETF, which just launched.
What I would say about the ETF is it’s also slightly different in terms of design. So the benchmark for the fund is a higher-quality benchmark. You would note that we have a much broader benchmark for the ETF. The strategy itself and what our portfolio managers are doing every day isn’t all that different. But we’re giving the portfolio managers more access to the lower-quality part of the universe where selection really plays an important role in alpha generation.
00:46:04 Rick Ferri
Why don’t you just launch, let’s say, a short-term high-yield bond index fund like iShares has iShares zero to five-year high-yield corporate bond ETF, SHYG. Why haven’t you gone down the road of indexing high-yield bonds?
00:46:22 Perryne Desai
I thought this was a Vanguard-oriented podcast. You guys are Bogleheads®. I’m kidding.
00:46:26 Rick Ferri
No, that’s totally fine. We can correct you there. We’re all about low cost, low tax, live below your means. I mean, we’ll go anywhere. We’ll go to Vanguard. We go to iShares. We go to wherever. Wherever.
00:46:41 Perryne Desai
Just kidding. I was just making a joke.
00:46:43 Rick Ferri
Well, we’re trying to keep you honest over there at Vanguard.
00:46:46 Perryne Desai
Oh, totally fair. You know, that was going to be my question for you was, like, we are consistently trying to listen to clients and better meet their needs. So I can’t comment specifically on index high-yield or short-term index high-yield product. But is that something you and your listeners would want?
00:47:06 Rick Ferri
Probably most of them really don’t care about high-yield corporate. I mean, it’s just something that I always had an interest in. And higher-quality high-yield, like double B rated, single B, not getting into the C range, which gets to be more like equity.
I’ve always said having a small portion of your fixed income portfolio in high-yield kind of rounds out a total bond market. Because if you think about it, as we talked about, the total bond market doesn’t have tips, doesn’t have high yield. So if you actually want a total bond market exposure in your portfolio, you need to add a little bit of tips and you need to add a little bit of high yield.
So what’s available out there? And what’s been available out there is basically the Vanguard fund, which is great. But not everybody has access to that fund, especially if they’re at some other brokerage firm.
00:47:51 Perryne Desai
Can I name drop you another one?
00:47:52 Rick Ferri
Sure. Go ahead.
00:47:53 Perryne Desai
We talked earlier about the aggregate bond index and how it’s been around for a long time. As certain parts of the market become more accessible to indexing, they become more approachable, let’s say. The index providers out there, like the Bloombergs, the S&Ps of the world, they’re all looking at ways in which they can continue to index these asset classes. And then asset managers create index products against them. It’s a really cool cycle of growth and innovation and almost democratizing access to less liquid parts of the market.
We actually just recently launched BNDP in December. It is our core plus index product. It’s managed against the US Universal, which has exposure to high yield and EM in an all-in-one index wrapper. So we do technically index a little bit today in high yield.
00:48:46 Rick Ferri
Interesting. So it adds high yields in emerging market. It doesn’t have TIPS. So you would need to add that element to it if you wanted to get sort of a true total market portfolio. And why would EM be in that portfolio, by the way, emerging markets?
00:49:01 Perryne Desai
So emerging markets is actually a part, it’s a normal and pretty standard part of the higher yielding fixed income sub-asset classes.
00:49:11 Rick Ferri
In the United States.
00:49:12 Perryne Desai
In the United States.
00:49:13 Rick Ferri
Through Yankee bonds, correct?
00:49:15 Perryne Desai
Yeah. These are Yankee bonds. These are bonds issued by governments and corporations in emerging markets that issue here in the US.
00:49:26 Rick Ferri
The total bond market or the aggregate bond market index has Yankee bonds in it, but it’s for developed markets only. So what you’ve done here is you’ve added emerging markets.
00:49:35 Perryne Desai
That’s right.
00:49:36 Rick Ferri
See, I know a little bit about bond indexing.
00:49:39 Perryne Desai
You know a lot more than you give yourself credit for.
00:49:42 Rick Ferri
Okay. Last words on where you’re going at Vanguard and what to look for in the future?
00:49:48 Perryne Desai
I think what’s really great about the evolution you’ve seen in Vanguard’s approach is we continue to think about the ways in which we can serve investors in more and differentiated ways. And so the products that you see us coming to market with, the innovation that you see across both our product lineup, our advice offering, our website design, we’re all trying to meet our clients where they are.
And sometimes that might mean that we are launching more narrow strategies across the complex because we have a huge advisor base and they’re really interested in slicing and dicing the universe more and more narrowly. Sometimes that might mean we’re launching products like a BNDP that have big, broad exposures to the various sub-asset classes.
And sometimes that means products like the target maturity ETFs that are coming out in late Q1 where there is an existing client need. Clients want to be laddering in portfolios and we want to help meet them where they are. And so we’re trying to find new ways to deliver great outperformance for active products and very tightly tracking index products to our investors so they can meet their investment objectives.
00:51:07 Rick Ferri
From us to you, what I think would be really helpful, as we already discussed, are target date municipal funds. I think that would be very interesting and helpful out there.
So a lot of people use munis to target liabilities. High net worth people are going to buy a vacation home or pay for a wedding or they have something going on. Or maybe they just want to ladder target maturity munis in their personal portfolio because they want to make sure they have enough money coming in every year to meet their retirement goals. And they’re in high income brackets. So there would be a really useful product, I believe.
00:51:46 Perryne Desai
I love that.
00:51:47 Rick Ferri
But thank you so much for your time today. We’ve covered an awful lot. And I appreciate you being on Bogleheads® on Investing.
00:51:54 Perryne Desai
Thank you so much for having me.
00:51:56 Rick Ferri
This concludes this episode of Bogleheads® on Investing. Join us each month as we interview a new guest on a new topic.
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