by Harry Sit on February 18, 2013 8 Comments

Back in June 2012, a reader asked in a comment on my post What to Do When Interest Rate Is So Low :

What would you think about this Vanguard Bond Fund for the next couple of years of low interest rate VWESX [Vanguard Long-Term Investment-Grade Fund]?

I said I wouldnt be comfortable with it because of the mismatch between next couple of years and long-term.

I was wrong. Vanguard Long-Term Investment-Grade Fund went on to become Vanguards second best performing bond fund in 2012, only after its high yield (aka junk) corporate bond fund.

A little while ago another reader commented on my post Bill Gross Got Lucky Again saying Vanguard Long Term Bond Index Fund easily beat PIMCO Total Return Fund in the last 10 years, which in turn easily beat Vanguard Total Bond Market Index Fund in the last 10 years. Just invest in the long-term bond fund for the long term; no active management magic was required.

Investment advisors usually recommend investing in short- or intermediate-term bonds. Here Im quoting The Only Guide To A Winning Bond Strategy Youll Ever Need by investment advisors Larry Swedroe and Joseph Hempen:

The rules of prudent fixed-income investing are:

Purchase assets with a maturity that is short- to intermediate-term, avoiding long-term bonds.

So it appears Swedroe and Hempen were also wrong. If someone read their book when it was published in 2006 and avoided long-term bonds, they would have missed a large gain.

Why did long-term bond funds do so well? Because interest rates came down. If you knew interest rates would come down you would be better off investing in long-term bond funds. But you didnt know. So investing in long-term bonds could only be attributed to being lucky.

Being lucky does wonderful things but counting on luck isnt a viable strategy. What about now? Should one invest in long-term bonds now ?

The answer is still the same. If interest rates stay the same or go down, you will get a better return in long-term bonds. If interest rates go up, you will get a worse return. Although some people say interest rate must go up, they have been wrong for years. There is no reason that interest rates, especially long-term interest rates, cant stay at the current level for years on end or even go further down. Although long-term bond investors were lucky, their luck may still continue to run for the foreseeable future. Or it may come to an abrupt end. Good luck figuring that one out!

After putting a bunch of money into principal-guaranteed vehicles, Im thinking of shifting my muni bond fund from intermediate-term to long-term. Why? Because I can. When I eliminate the interest rate risk on the short and intermediate portion with savings accounts, CDs, I Bonds and what not, I have more capacity to take risk on the long end. Wall Street has a fancy name for this called the barbell strategy .

In addition, Vanguards so-called long-term muni bond fund isnt that long anyway. Compared to the intermediate-term muni bond fund, the long-term fund adds only 1 year to the average maturity and the average duration (6.x years vs 5.x years). For the added 1 year, I get a 0.5% higher SEC yield and a 0.75% higher distribution yield. I think its worth the switch.

[Photo credit: Flickr user Wonderlane ]

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