Vanguard Short-Term Investment-Grade Fund Gets Cautious

When interest rates rise, bond prices fall. That's the story behind the bond market over the past 12 months, and the Vanguard Short-Term Investment-Grade Fund (VFSTX) – a member of the Kiplinger 25 – shows it.

The fund's negative 2.1% return over the past 12 months trailed its peers, but beat the Bloomberg U.S. Aggregate Bond Index, which lost 3.6%. (Returns are through Feb. 4.)

Interest rates in bonds of all maturities inched higher last year, but short-term rates lifted off from near zero. The two-year Treasury note, which 12 months ago yielded 0.11%, now sits at 1.31%.

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That kind of rise will create a negative total return in the fund, which invests in mostly high-quality corporate debt of one- to five-year maturities, says Arvind Narayanan, one of the fund's three comanagers. "Even a short-term-bond fund is sensitive to interest-rate moves."

A year ago, the managers positioned the fund for an economic recovery. They devoted a bigger chunk of assets to triple-B bonds, which boast higher yields. In particular, they homed in on bonds issued by high-quality companies, such as Boeing (BA), that saw their credit ratings slip to triple-B, the lowest rung of investment grade.

"These are bellwether blue-chip names that were willing to sacrifice some of their balance-sheet strength to load up on cash," he says. "That's when we stepped in, because we understand their strategy, and we're being compensated to hold their debt." These positions helped the fund's results – though it isn't obvious from the fund's one-year return – as did a 2% exposure to high-yield issues (bonds rated double-B to triple-C).

The managers are more cautious now and expect volatility ahead. "We're likely to see higher sustained inflation and slowing economic growth," says Narayanan.

They shed some investment-grade and high-yield debt to load up on cash and Treasuries, where 12% of the fund now sits. "We upgraded the portfolio to make it more weatherproof for volatility" and to have cash ready to put to work when the dislocations occur.