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Rate missteps move Vanguard from forefront of bond market

For years, Vanguard could boast that conservative management, high-quality portfolios and rock-bottom expense ratios made its bond funds inevitable long-term winners. But you'll find none of them in short-term or long-term winners' circles these days.

In their category, Vanguard's eight high-quality corporate-bond funds are trailing the leaders in total return over the past three and five years - a state of affairs that is highly unusual in the history of the Valley Forge, Pa., firm. The typical Vanguard bond fund is turning in merely average results in 1997. So what's going on?Ian MacKinnon, who supervises 27 of Vanguard's 30 bond funds, says that competing funds have loaded up on higher-risk securities, such as bonds of developing nations and high-yield "junk" bonds, and these have performed magnificently.

Vanguard won't play that game, MacKinnon says. Its investment-grade funds hold no junk and no emerging-markets debt.

But MacKinnon is also part of the problem. The 49-year-old bond whiz likes to tilt the maturities of his fund portfolios slightly in anticipation of what he expects will happen to interest rates.

To be sure, MacKinnon doesn't ever radically lengthen or shorten his maturities. Vanguard is too conservative to allow such big wagers.

But early in 1996, he bet on lower interest rates and they rose. Since May of this year, he has bet on higher rates and they've fallen.

"If you're a bond manager and you weren't invested in long-term bonds much of this year, you've given up both yield and price appreciation," says Kathleen Gaffney, co-manager of Loomis Sayles Bond, a competing fund.

What now? To all the talk about inflation being dead, MacKinnon says phooey. He foresees a classic wage-price spiral: "I don't see it as a matter of if but when."