Highlights of the Current Issue
of The No-Load Fund Investor

From The No-Load Fund Investor, 3/08...

Preparing for Tomorrow

February was a volatile month that ended on the downside for most types of stock funds. Most of the month’s big gains were notched by natural-resources funds, which produced a return on average of 8.7% for the month. Many international markets staged mile rebounds after a rough January. Financials reversed their relatively strong January performances with another big downturn in February as it became increasingly clear that additional cash infusions would be necessary in the face of more bad news on asset values and capital needs within the sector.

Our general view on the stock market hasn’t changed. Valuations and Fed policy lead us to feel barely comfortable enough to maintain our published asset allocations for now. However, we have become dismayed by the increasingly cavalier manner in which the Congress, the Federal Reserve Board and especially Fed Chairman Bern Bernanke have discussed the problem of increased inflation in recent speeches and appearances. It seems to us that by some of his recommendations, Chairman Bernanke is exhibiting a vulnerability to political pressures on issues of unemployment, consumer spending and the housing situation instead of standing up for price and currency stability. As a result, commodity prices are rising as is inflation generally, and the dollar continues its descent. These factors are likely to hurt the market’s chances for a sustained recovery.

Bond-Fund Choices

As a table of selected Vanguard bond funds included in our March issue shows, the U.S. bond market over the past 12 months divided sharply between winners and losers. For example, the table shows that the 1-year return on long-term Treasuries was 10.3%, compared to -3.5% for long-term high-yield tax-exempt bonds. The gap is even greater in intermediate maturities, as intermediate-term Treasuries returned 13.1%, compared to -2.3% for intermediate-term high-yield corporates.

Treasuries of various maturities gained nicely, thanks mainly to a flight to quality on the part of investors concerned with the subprime crisis, carryover effects to other credit-sensitive bonds, and general economic distress. Plain-vanilla high-quality corporate bonds and mortgage-backed securities produced modest to moderate total returns. Intermediate- and long-term municipal bonds and low-quality high-yield corporate and municipal bonds actually lost money.

These total-return disparities have engendered some unusual yield comparisons. The most dramatic are those between Treasuries on the one hand and high-quality municipal bonds on the other. For example, Vanguard’s intermediate-term Treasury fund yielded 2.91% as of the end of February, compared to 3.52% for the intermediate-term tax-exempt fund. This is virtually unheard of. Unlike Treasury interest, interest on municipals is free from federal taxation. As a result, pre-tax yields of high-quality municipal bonds are typically 10% to 20% lower than those of Treasuries, not 10% or 20% higher. That way, most investors end up with a little more after-tax yield from municipals than from Treasuries, befitting the latter’s top-of-the-heap credit quality. With pre-tax municipal yields actually above Treasury yields, investors can get about 50% more after-tax yield from municipal bonds.

On the face of it, that seems very attractive. However, municipal securities have been buffeted by numerous factors, several of which are fundamental in nature. One, many states are experiencing declining fiscal conditions. Fiscal imbalances are widening because tax revenue is coming in lower than budgeted when the economy was stronger. At the same time, state government spending continues virtually unabated. Two, many states’ long-term pension obligations for state government workers are underfunded, as expected investment returns within pension plans aren’t panning out. Three, the insurance upon which many municipal bond issuers relied to increase their bonds’ credit ratings and lower interest cost has been show to be at risk, due at least in part to the fact that the insurers themselves invested in what is now drastically marked-down debts.

Because of the current high relative yields among municipal bonds, we think now is a good time for investors in at least the 25% tax bracket to hold high-qualify municipal-bond funds, especially of the intermediate-term variety. If you own such funds already, don’t be scared out of them by recent bad market action.

However, we certainly wouldn’t suggest switching all of your fixed-income money into municipal-bond investment. The long-term fiscal problems at the state level are real and stubborn, and there seems to be little appetite anyway for the type of spending restraint required to put many states on a fiscally sustainable path. If you currently own no municipal-bond investments, we would advise building up a position to a maximum 40% of your total fixed-income holdings outside retirement plans.

Model Portfolios

Sample Model Portfolio from the Current Issue
of The No-Load Fund Investor

Wealth Builder Portfolio

Top Twenty No-Loads

Among stock and bond funds rated in Investor newsletter only. Includes low-loads. Lastest 12 Months.

#   Fund                            Obj.       % Change
---------------------------------------------------------
1.  CGM Focus                      agg gr        71.8
2.  Price Latin America            int’l-emerg   51.0
3.  GAMCO Gold AAA                 sector        49.4
4.  Fidelity Latin America         int’l-emerg   49.0
5.  Vangd Prec Met and Mining      sector        48.6
6.  USAA Prec Metals & Mins        sector        46.8
7.  PowerShares DB Comm Idx Track  sector        46.2
8.  Guinness Atkins China & HK     int’l-emerg   45.8
9.  PIMCO Commodity RealRet D      sector        45.3
10. Fidelity Sel Gold              sector        45.1
11. iShares COMEX Gold             sector        44.8
12. Matthews India                 int’l-emerg   44.1
13. Fidelity Sel Energy Svc        sector        42.9
14. Price New Asia                 int’l-emerg   42.7
15. US Glb: Glbl Resources         sector        42.7
16. AIM Energy Inv                 sector        41.8
17. Fidelity Sel Natural Res       sector        41.6
18. Matthews China                 int’l-emerg   41.5
19. Fidelity Sel Energy            sector        40.7
20. US Glb: Gold Shares            sector        39.2