In recent months, investors have been peppering Vanguard with questions about how they should react to prospects of rising interest rates, including whether they should reallocate their bond portfolios defensively into shorter-maturity funds before rates start to go up, the firm said in a May 11 statement, announcing publication of a new research paper, “Deficits, the Fed, and rising interest rates: Implications and considerations for bond investors.”

That a leading fund provider would be hearing these concerns is not surprising. U.S. investors have been pouring money into mutual funds for more than a year. Indeed, U.S. bond and stock mutual funds are on track to set a record for annual inflows in 2010, topping last year’s record of more than $400 million, according to business information provider Strategic Insight (SI).

Bond mutual funds have been a huge beneficiary of these inflows, Vanguard said, reflecting both the pursuit of a safe harbor from recent stock market volatility and the search for higher income than that offered by money market funds. In the year to March 31, U.S. bond mutual funds and ETFs absorbed $430 billion, the statement said, citing SI figures.

The Vanguard research paper, written by the firm’s chief economist Joseph Davis, discusses two related issues:

? Why long-term U.S. interest rates, such as the 10-year Treasury yield, are below 4%, given the expected future path of government debt levels and the Federal Reserve’s “exit strategy” for tightening monetary policy. Don’t long-term rates have to rise dramatically?

? How bond funds might perform if rates should rise in coming years?

Davis approaches these questions by deconstructing the yield on a 10-year Treasury bond into its components, including inflation expectations, anticipated Fed policy, and the effects of changes in bond supply (i.e., deficits) and demand. This exercise reveals that the expected upward pressure from the fiscal deficit on long bond rates has been offset so far by increased bond demand arising from a higher domestic savings rate.

It also provides a basis for assessing the future economic scenario that is “priced into” today’s bond valuations (and hence into the forward yield curve), leading to a discussion of why expectations for future interest-rate movements seem generally plausible.

Davis concludes, most broadly, that scenarios producing the highest relative returns in the short run (such as a double-dip recession scenario) would be expected to produce the lowest relative returns over the long run. Conversely, scenarios in which rates rise more than is currently expected (such as from a fiscal crisis or a run-up in inflation) could actually produce the highest relative nominal returns over a 10-year period.

“The results of our scenarios, together with the performance of various bond segments over the past several years, underscore the benefits of a broadly diversified fixed income portfolio regardless of the future direction of interest rates,” Davis writes. “A key lesson of the global financial crisis is that implementing a too narrow or ‘surgical’ bond allocation (such as by shortening duration or investing solely in riskier bond instruments) involves important trade-offs that may expose investors to unintended yield-curve or credit risks, while potentially depriving them of a higher or less volatile future income stream. The high uncertainty surrounding the future direction of economic growth, the deficit, inflation, and interest rates would seem to support greater fixed income diversification, not less.”

Read a story about Strategic Insight’s report on fee-based funds from the archives of

Read a story about Strategic Insight’s survey on fund inflows from the archives of

Michael S. Fischer ( is a New York-based financial writer and editor and a frequent contributor to Wealth Manager.