Is there a risk in this fund if they invest only in U.S. Treasurys? This seems to be one of those "too good to be true" deals. I can't help feel that I am misunderstanding something.
---J.S., by e-mail from Dallas
A. You are misunderstanding something and you have lots of company. Equally important, this isn't unique to the Vanguard Long Term Treasury fund--- most funds that invest in long term government bonds have provided handsome total returns over the last 10 to 20 years.
The average return of 89 long term government bond funds over the 12 months ending June 30, for instance, was 11.82 percent. (The data is from Morningstar.) The same figures for the last 3, 5, 10, and 15-years, respectively, were 9.94, 9.44, 7.50, and 9.19 percent.
There is a simple explanation for this. According to the Treasury constant maturity index history available on the Dallas Federal Reserve Bank website (http://www.dallasfed.org/data/data/rmgnb20m.tab.htm), the highest yield on a 20-year Treasury bond was 15.13 percent in October 1981. The peak average yield for a year was 13.72 percent in the same year. Many have forgotten the staggering interest rates of the late '70s and early '80s.
Since then, bond yields have declined. On 20-year Treasurys, yields averaged 10.97 percent in 1985, 7.85 percent in 1986, and continued a slow decline. The low yield on a 20-year Treasury was 4.34 percent in June 2003. The current yield is about 4.60 percent.
Now ask yourself a question. A man is offering you two bonds with a face value of $1,000. One pays interest at 12 percent and will give you two payments a year of $60. The other pays interest at 4 percent and will give you two payments a year of $20. Otherwise, the two bonds are absolutely equal.
Which bond would you rather own?
It doesn't take an MBA to know that you'd be better off buying the bond that pays $120 a year. Indeed, investors will pay quite a bit more for a bond that pays $120 a year than for a bond that pays $40 a year.
When a mutual fund that invests in long term bonds lists its annual return or its average return it is the total return of the fund. The total return is the combination of the interest income received plus (or minus) the change in value of the portfolio. When interest rates decline, a portfolio of bonds that pay $120 a year will rise in value relative to bonds that pay less. So the total return of the fund will rise because the bonds could be sold for more than their original purchase price.
Part of the total return provided by long term bond funds in the last 20 years has been capital gains.
Bond fund owners probably won't enjoy such high returns in the future. With interest rates below 5 percent there isn't nearly as much room for decline. It would take a continued decline in interest rates to provide those 8 percent returns for a few more years.
Bond investors should be worrying about the other side of the coin--- the loss in market value when today's 4.6 percent coupon Treasury bonds, which pay $46 a year, will have to compete with newly issued bonds that may pay $50 and $55 a year because they have coupons of 5.0 and 5.5 percent.
When interest rates rose in 1999, for instance, the average long term government bond fund lost 8.23 percent, despite its interest income.
While interest rates could decline still further, the odds now favor flat to rising interest rates.
This article contains the opinions of the author but not necessarily the opinions of AssetBuilder Inc. The opinion of the author is subject to change without notice. All materials presented are compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. This article is distributed for educational puposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product, or service.
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