VWEHX: Vanguard High-Yield Bond Fund

VWEHX, the Vanguard High-Yield Corporate Fund, has been a great to investors since its inception in December 1978. VWEHX has generated 8.41% annual returns durings its thirty-two years in existence, which would turn a $10,000 investment into $146,000 over that time frame. Better yet, VWEHX has been the near perfect bond fund to own if you are after high current over the long run, as $108,000 of those gains would have come from income generated from the bond holdings that would be passed on to you.

The terms of a VWEHX would have been this: For every dollar you put into the investment, you got to collect $10.80 in total over the span of regular monthly payments that occurred over the following 30+ years. VWEHX has been the best way to enter the junk bond market, as the strategy involves buying over four hundred companies with low credit quality and then owning their debt that has historically averaged somewhere in the 8% to 9% range. Factor in the defaults, and the fund generates about 7% annually in income as its three-decade average. The extra percentage point that has taken the overall VWEHX return to the 8.41% level is the result of decades of declining interest rates that have pushed up the price level of bonds.

When you invest in bonds, be it VWEHX or anything else, and choose to live off the income, you should not expect much of anything in the form of capital appreciation–nearly your entire investment is related to a specific contract claim for the debt of a risky corporation and you should have no expectation for a growth component. The $38,000 in capital gains that were generated for WWEHX over the past thirty-two years is almost guaranteed to never be repeated anytime soon, and especially over the 2016-2048.

The prime rate is currently 3.5%. In December 1978, at the time of the VWEHX fund launch, the prime rate was 11.75%. The near quadrupling of capital gains for holders of VWEHX is closely related to the fact that the prime interest rate in 1978 was 3.35x the prime rate that exists today. From the 2016 measuring period onward, it is exceptionally likely that the prime rate will be north of 3.5%, and then the price of bonds will fall to adjust for higher interest rates.

In other words, the terms of a three-decade VWEHX investment were something like this: You got 7% in income, and about 1.5% in capital appreciation due to falling rates, and that marked your total return. Over the coming years, you’ll probably lose a percentage point or maybe a little bit more to adjust for the rising rates.

The current SEC yield from the fund is 5.6%, which is about a point or two lower than historically normal. If you purchase today, you will probably only make something in the 4% over the medium-term. You’ll be collecting somewhere between 5% and 6%, and then you’ll be sitting on a percentage point paper loss. As time drags on, the amount of rising income generated by the underlying VWEHX holdings will begin to dominate over the falling bond prices that are caused by higher interesting. The fund will earn more as bonds mature and new debt is purchased with higher interest rates than exist now. If your time horizon is 15+ years, I’d imagine VWEHX would give you returns of around 6% (higher income than you get now, but there may still be a modest paper loss dragging you down).

The low interest rate environment has kept me from writing about a lot of interesting funds that consist of diversified corporate debt obligations and are useful inclusions to an investment portfolio because they become reliable sources of cash. Imagine if, ten years ago, someone was preparing to receive income in 2016 and purchased $25,000 worth of VWELX with the intent to reinvest for ten years and then start collecting the income thereafter. That person would own 8,212 shares of VWELX trading at $5.58 per share and generating around $0.02495 in income every month. The $25,000 investment would have grown into an income stream of $204 per month. It would be contributing $2,448 towards your income each month, giving you a 9.8% yield-on-cost due to the repetitive compounding effect of spending ten years reinvesting.

But unfortunately, now is not the right time to load up on shares of VWELX. You want to consider junk bond funds when interest rates are (1) generally high, (2) declining, (3) and/or the economy is weak and credit is tight and the companies that do successfully borrow have to do so at higher rates. This is the exact opposite of that environment–rates are generally low, going to be rising, and we are six years into an expansion in which low-quality companies might be getting away with paying the lowest interest rates they will incur over the course of the business cycle.

This could very well be one of the worst times to consider purchasing the Vanguard High Yield (VWELX) fund. I don’t blame Vanguard for this. They are sticking to the script–purchasing a diversified selection of junk bonds that do give you a nice current income of 5.6%. But the external business conditions do not support buying it at this time. Wait for rates to go up two points, or the credit markets to tighten, and then give this fund a good look. It belongs in your back pocket as something to consider because the monthly income has been historically high and reliable because you’re still collecting 6% even in a high-default recession, but the current conditions aren’t right. It’s a very useful income fund, but there’s no “growth” kick to protect you if you get the timing wrong.

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Originally posted 2016-03-28 20:28:01.

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