Wednesday, August 20, 2008

Treasury Bonds, Tax-Exempt Bonds, and Corporate Bonds: Year-to-Date Returns

One way that investors signal their sentiment toward the economy is through their differential interest in various classes of bonds. If there is a flight to safety, we expect Treasury bonds to outperform other bond classes. If investors are risk-seeking, they will gravitate to high-yield bonds. If the outlook is questionable for companies, we will see corporate bonds underperforming Treasuries and tax-exempt bonds.

For this look at year-to-date performance among bond classes, I examined bond funds within the Vanguard family. Here are some of the observations:

1) Treasuries have outperformed - Intermediate-term Treasuries (VFITX) and long-term Treasuries (VUSTX) are the only groups with positive price returns for the year.

2) Intermediate-term has outperformed long-term - Price performance has been better for intermediate-term tax exempt bonds (VWITX) than for long-term tax exempts (VILPX); for intermediate-term investment grade corporate bonds (VFICX) than for long-term investment grade corporate bonds (VWESX).

3) Investment grade has outperformed high yield - Price performance has been better for long-term investment grade corporate bonds (VWESX) than for high-yield corporate bonds (VWEHX); slightly better for insured long-term tax-exempt bonds (VILPX) than for high-yield tax-exempt bonds (VWAHX).

We we see is that, in relative terms, bond investors have been gravitating toward safety (Treasury yields) and away from corporate and high yields. With concerns regarding inflation and perceptions of a maintenance of Fed ease, intermediate-term bonds have outperformed long-term ones.

It is when we see underperformance at the shorter-end of maturities and among Treasuries relative to corporates that we'll know that themes have changed (tighter Fed, more confidence in the economy). I'm also watching the relative performance of tax-exempts to see if they are hurt by continued housing weakness (and questions about municipal defaults) or if they become bond darlings in the face of likely tax hikes from the next administration.