The fixed income market, often upstaged by the higher-profile equity market, recently has come into a spotlight of its own. Several unusual circumstances, including the inverted yield curve and the reintroduction of the 30-year Treasury bond, have thrust bonds into focus over the past several quarters. During a recent interview, Robert F. Auwaerter, principal and head of Fixed Income Portfolio Management at Vanguard, discussed some of the issues facing bonds.

Mr. Auwaerter has direct oversight responsibility for all money market, bond, and stable value portfolios managed by the Fixed Income Group. Having managed investment portfolios since 1978 and at Vanguard since 1981, he is a recognized expert on the fixed income markets.

Note: A portfolio manager's opinions about a given investment or securities market are subject to change.

There has been a lot of attention given to the yield curve lately. Has Vanguard modified its fixed income portfolios in response to the flat-to-inverted yield curve?
We made some adjustments given our expectations that the Federal Reserve would continue raising the federal funds rate. Generally, the front end of the curve is most responsive to changes in the Fed target rate, with the biggest impact seen out to two or three years. Since we expected short-term rates to rise through 2005 and into 2006—which has come to fruition—we generally underweighted the two- and three-year part of the yield curve. We implemented a barbell structure, keeping a fair amount of money in very short-term instruments that would be responsive to rises in the federal funds rate. We counterbalanced this position with a weighting in longer-dated instruments that we thought would not be quite as responsive. It was our belief that the intermediate-to-long section of the yield curve would not react as fast as it has at other times in response to changes to the federal funds rate.

For our money market funds and short-term bond funds, we generally shortened the interest rate sensitivity or the duration of these portfolios to try to shield them from higher interest rates. In the second half of 2005, we ran the intermediate- and longer-term portfolios fairly close to the midpoint of their respective benchmarks. We implemented this neutral position given our belief that strong demand for intermediate- and longer-dated assets from institutional investors looking to match long-dated liabilities would continue.

After being eliminated in 2001, the 30-year Treasury bond was reintroduced recently. Do you anticipate strong ongoing demand for the long bond? How will the bond's comeback shape the fixed income markets, particularly with regard to duration?
We've already seen one long-bond auction for which demand was extremely strong. I believe future auctions will see the same type of demand. There has been a growing need for longer-dated assets to offset longer-dated pension liabilities. We've observed this trend not only here in the United States, but in markets abroad. Several countries in Europe have issued very long-dated bonds which have been met with robust demand. The desire to match long-dated liabilities with long-dated assets is becoming a global phenomenon.

Do I believe these longer-dated bonds will lengthen the overall duration of the fixed income market or select benchmarks? At this point, I don’t believe there will be any significant changes in duration. There currently is just not enough issuance to have that big of an impact.

Do you have any concerns about the growing federal deficit and its impact on fixed income securities?
All things equal, a growing federal budget deficit will push interest rates higher. However, the overall impact will be determined by the extent that the deficit crowds out other borrowers. For example, if you had a situation where corporations and households were also trying to borrow a significant amount of money, the confluence of these three groups of borrowers would likely trigger higher interest rates in the marketplace.

During the 1980s, the Reagan administration ran what were extremely high deficits for a nonwar period. Yet interest rates in general fell all during the 1980s. Rates dropped because inflation expectations and the actual rate of inflation were decreasing. The moral here is that you can't look solely at the federal budget deficit and determine a one-to-one correlation with its impact on interest rates. The effect is much more subtle than that.

Currently, the federal budget deficit is being funded substantially by foreign investors. This dynamic is linked to another deficit—the growing U.S. trade deficit. When dollars go overseas to buy cars or other goods, those foreign countries have been reinvesting the funds in U.S. financial markets. However, this trend will likely reverse over time as the value of the dollar versus foreign currencies falls, foreign goods become more expensive, and U.S. consumption of those goods drops. The question is whether it will correct rapidly or smoothly. Many experts who were concerned when the trade deficit was about three or four percent of GDP are now wondering what deficit level relative to economic growth finally will make the process begin to reverse itself.

As the first baby boomers reach retirement age this year, do you expect a growing shift into bonds?
Most people equate more conservative allocations with greater allocations to bonds, but this isn't always the case. Faced with the fact that they will likely live longer than their parents, baby boomers can't necessarily afford to be overly conservative.

In general, we are seeing cash flows from some baby boomers, particularly those who are using targeted retirement or life-cycle funds. These investors definitely have created more cash flows for the bond markets. However, the overall impact has been obscured by other participants in the market. Right now, cash flows from foreign investors represent a much more significant trend than any money coming from baby boomers.

Despite steady increases in short-term interest rates, yields remain historically low. A growing number of portfolio managers have turned to derivatives as a way to add incremental returns or protect against market volatility. What is Vanguard's position on the use of derivatives in bond portfolios?
Like any other instrument, there are good derivatives and bad derivatives. Vanguard uses derivatives judiciously, as a hedging instrument or to replicate a bond at a better price than what is available in the cash markets. We don't use them to take positions which are contrary to the investment objectives of a fund.

In many cases, derivative securities are actually more liquid than the cash markets. Interest rate swaps are prime examples. I would estimate that liquidity in that market is second or third behind Treasury securities and equal to or slightly better than mortgage-backed securities. Large amounts of money trade in interest rate swaps with very tight bid-offer spreads. With these derivatives, you can adjust the portfolio sensitivity to changes in interest rates or to changes in the yield curve very quickly and with very little cost to shareholders.

Credit derivatives can be used to simulate an investment in a corporation's bonds in such a way that either creates that position with a lower cost or with the potential for a higher return. The important point for Vanguard shareholders to realize is that we only use derivatives in ways that are consistent with the overall investment objectives of the fund.

Are you evaluating any other exogenous events that could impact the fixed income markets?
There's always something on our radar screens. Right now we're evaluating what impact an outbreak of avian flu in the United States might have on the financial markets. Whenever there is a crisis, the initial reaction in the market is typically a flight to quality, which has a direct impact on the portfolios we manage. For example, when the London terrorist bombings first occurred, there was a strong rush of money into U.S. Treasuries to the extent that we thought the inflows were overdone. We sold securities and later bought them back, benefiting our shareholders. We certainly look at different types of possible scenarios and begin to think about what impact they might have on the economy and in the financial markets.

Notes

• Mutual funds are subject to market risk.
• Investments in bond funds are subject to interest rate, credit, and inflation risk.