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.