A Chat with Vanguard's Ian MacKinnon

The Fed is behaving as if there may be appreciably more damage down the road

By Robert Barker

One day, interest rates will stop falling, bond prices will top out, and stocks will look like a better bet. Just don't count on it any time soon, says Ian MacKinnon, the Vanguard Group managing director in charge of its $185 billion in fixed-income assets.

MacKinnon, whom I reached by phone this week after the Federal Reserve's Open Market Committee cut interest rates for the seventh time this year, spies special opportunity for bond investors in intermediate- and long-term bonds, such as those in Vanguard Long-Term Tax-Exempt Bond Fund (VWLTX ) or Vanguard Intermediate-Term Corporate Bond Fund (VFICX ). Edited excerpts of our discussion follow:

Q: What did you make of the Fed's interest rate cut this week, and the market's sell-off after the news?


The presumptions we made were that: (a) the markets were hoping for more and didn't get it, (b) that the economy is probably weaker than people had previously considered, and (c) that while some of the indicators seemed to point to us having bottomed out economically, the Fed is behaving as if there may be appreciably more damage to be endured down the road.

Q: Do you expect further cuts in interest rates when the Fed next meets in October, and perhaps beyond?


Absolutely. We think that the easing on the part of the Fed, while commendable in its speed and magnitude, isn't going to be sufficient to revive consumption [and] retail sales. Certainly not enough to revive capital spending. [There's] just too much excess capacity that needs to be absorbed.

As far as the global situation is concerned, the world economy seems to be in sync with the U.S. and is slowing in Europe and in Asia. The combined effect is to weaken our export markets. We're lowering our interest rates domestically, but so are our trade competitors abroad, and the dollar remains strong.

Q: What about the euro, which has been gaining strength? Doesn't that bode better for U.S. export industries?


Eventually. But what happens initially is that the imports become somewhat more expensive from Europe because of the strength in the euro, and that sort of kicks into a worsening of inflation. So there are really no significant signs of encouragement that we see on the near-term horizon.

On top of that, you've got significant layoffs going on across the telecommunications sector, and it's starting to bleed into other sectors, like Wall Street, where the fantastically well-remunerated investment bankers are finding that the IPO market has essentially dried up.

Q: Your counterpart at Pimco Funds (PTTAX ), Bill Gross, this week indicated a fear of foreign investors liquidating their dollar-denominated assets if they expect the dollar to fall. What's your outlook for the dollar, and how that might affect our bond markets?


I'm not particularly worried about foreigners liquidating bond holdings because foreign investment in bonds is really the flip side of the trade deficit. As long as we keep importing billions of dollars more than we export, those dollars have to find their way back into the system. And it's very unusual for those dollars not to find their way back into the bond markets.

Q: All in all, you're painting a relatively bullish picture for bond investors here over the next year or so.


Yes. And a somewhat gloomier outlook for corporate earnings and the stock market.

Q: Many individual investors focus on municipal bonds. What's the outlook in muni-land now?


The states are feeling the same impact that the federal government budget is facing. That is revenues -- or the growth in revenues -- is dropping quite dramatically, so that the formerly rosy fiscal scenario for the states has turned somewhat bleaker over the last couple of months.

Q: I see.


That said, the creditworthiness of state [general-obligation bonds] and most of the revenue-bond market -- in fact most of the municipal-bond market -- might be marginally impaired but certainly not seriously. As a consequence, municipal bonds are a very attractive place to be right now. Particularly intermediate- and long-term munis.

Q: Would be that five-year maturities and longer?


I would say more like 10 years and out.

Q: What kind of investors should consider munis for their taxable accounts?


Anyone in the 28% tax bracket and higher.

Q: Washington has been discussing issuing fewer Treasury Inflation-Indexed Securities, or TIPS. Is that a worry to you?


Yes. We believe that TIPS is a unique asset class in the U.S. It's the purest protection one can get against inflation without taking any credit risk.... We think it's an attractive asset class for individual investors who are putting part of their retirement money aside and want to hedge it against inflation.

It's disturbing to us that the Treasury, after spending a considerable amount of time and effort developing the idea and then coming out with multiple billions of dollars of issuance, is thinking about abandoning the program. We believe TIPS are a great deal for investors, which might make you believe that they're not a great deal for the Treasury and consequently for taxpayers. However, we think the TIPS market has attracted investors that wouldn't otherwise have bought Treasuries.

We believe the overall demand for Treasury securities has gone up -- and we can certainly corroborate that based on the cash flows and exchanges that we've seen in our own mutual funds.

Q: Which class of securities is losing market share to TIPS? A: Equities. Our exchange activity at Vanguard -- and it's in the millions and millions of dollars -- has been predominantly out of equity funds into TIPS, as opposed to out of other bond funds into TIPS.

Q: Should investors then hesitate to put money into a TIPS fund if the government retreats on issuing TIPS?


There's always going to be a relatively liquid market in TIPS as long as they exist...so we would not expect their liquidity to be any worse than a very high-quality investment-grade corporate bond.

Q: What else should individual investors focus on right now?


There's a sweet spot on the yield curve between 5 and 10 years, where you get essentially the yield of a long bond and the risk of an intermediate bond. If interest rates do decline, that particular segment of maturities -- from 5 to 10 years -- is probably going to do pretty well. So I think that the risk-return trade-off in that range is quite attractive for investors.

Q: In what kinds of bonds?


Medium- to high-investment grade corporate bonds probably represent probably a pretty good deal.

Barker covers personal finance in his Barker Portfolio column for BusinessWeek. His barker.online column appears every Friday, only on BW Online

Edited by Patricia O'Connell

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