Dec 20th, 2007
Where to Fly to in a Flight to Quality
The recent subprime panic has resulted in a “flight to quality” in the bond market. What does that mean?
Bonds, which are the debt of corporations or government agencies, are rated, just as our own credit is rated when we apply for a loan. Just like the interest rate on your mortgage depends on your credit rating, the interest rate paid on bonds depends on (among other things) the rating of the bond. If you are willing to take a lot of risk, you’re rewarded with a higher interest rate, but taking more risk of default; if you aren’t willing to take on much risk at all, your interest rate will be lower.
With so much concern about subprime debt, those who have stakes in the bond market have been looking for bonds with better ratings. So there’s more demand for government bonds with better ratings today as the government is a lot less likely to default than other borrowers. Where do we go to get the quality that everyone else appears to be flying to?
Here are two alternatives, both from Vanguard: the Vanguard Total Bond Market Index Fund, and the Vanguard GNMA (Ginnie Mae) Fund.
The Vanguard Total Bond Market Index Fund (VBMFX) is, in the Vanguard style, an index fund, no load, with a low (.20%) expense ratio that tracks the performance of a “broad, market-weighted bond index.” Currently, the fund is up 6.59% year to date and pays a yield of 4.93%.
The Vanguard GNMA Fund (VFIIX) is not an index fund, although it is no load with almost as low (.21%) expenses. This fund invests most of its assets in Government National Mortgage Association certificates; basically, AAA rated government backed debt. This fund has returned 6.96% this year to date with a 5.11% yield.
These funds are both low cost, no load, and from a company that has a long history of quality and performance. I would be comfortable with owning either fund; unfortunately, my 403(b) plan only offers the VBMFX fund of the two. If I had an opportunity to choose, I’d take the VFIIX (there’s no better quality than AAA government backed), but either one has the quality that bond investors fly to in these trying subprime times.
[...] government agencies, are rated, just as our own credit is rated when we apply for a loan. Just likehttp://www.uncommon-cents.net/2007/12/20/where-to-fly-to-in-a-flight-to-quality/Vanguard – Product overview.Portfolio of gnma mortgage-backed securities. vanguard style view–four [...]