Thoughts on Choosing Bond Index Mutual Funds

Now that Vanguard allows us to waive all their $10 low-balance fees, I need to reconsider my choice in bond funds. But which one? Here’s a my brief and very generalized understanding of bonds, based on my own readings. Please use this only as a starting point for your own research.

Quick Bonds Primer
Bonds are essentially loans, either from government or private companies. In portfolios, they are usually used to reduce the overall volatility because of their low correlation with stocks. When stocks go one way, bonds tend more to go the other (thought not always). This can allow you to lower risk without significantly lowering returns. See this Vanguard illustration.

While there are many different types of bonds – corporate, mortgage-backed, U.S. Government Treasuries, municipal, to name a few – you can break them down into two ways:

Maturity Risk
The longer the loan length, or time until maturity, the more sensitive bond prices are to interest rate fluctuations. Bonds are often grouped into short-term, intermediate-term, and long-term categories. The lender (us) is usually compensated for this extra volatility with higher returns. Another way to measure sensitivity of a bond fund is by looking at the duration. For example, if a bond has a duration of two years, its price would fall about 2% when interest rates rose one percentage point. On the other hand, the bond’s price would rise by about 2% when interest rates fell by one percentage point.

Credit Risk
Just like with consumer loans, the worry is about defaults. The riskier the borrower is, the higher interest they must pay. Given the same maturity length, a junk bond with a low credit rating will pay a higher return than a government-backed Treasury bond. Foreign bonds aren’t very popular, due to the added currency risk and also higher expenses.

Where’s the best risk/reward combination?
Just because as risk goes up, return goes up, doesn’t mean that there is a linear relationship between the two. You want to find the best combination for your portfolio needs.

Regarding credit risk, in general it best to concentrate only the highest-quality bonds. You are not rewarded terribly well for taking a lot of extra risk. It is much more efficient to make your stock holdings more aggressive instead if you want higher expected returns. Again, bonds are the safe part of your portfolio.

As for maturity risk, the rule is to keep it short. This chart from IFA.com shows us why: stretching the bond maturities from 1 year to 20 years for Treasury bonds only gives you about 0.50% higher returns, but almost double the volatility. Most books seem to suggest a maximum maturity of about 5-7 years, and this EfficentFrontier.com article agrees.

altext

Up to now, I’ve left out TIPS, which are Treasury Inflation-Protected Securities. They are different from other bonds in that they are designed to protect investors from unexpected inflation by guaranteeing a real rate of return. Some people really like these, but since they’ve only been around since 1997, it’s hard to predict their future returns. All bonds already have an assumed inflation component factored in, so I don’t think their long-term returns will be significantly different from other bonds with similar maturities. However, the key word is unexpected inflation, so it may be a worthy addition.

Finally, just like with stock funds, diversification and costs matter. You don’t want to buy individual bonds, so you spread the risk with mutual funds. The bond market is very efficient and higher expense ratios simply eat into the returns, which are already significantly lower than that of stocks. (An exception is Treasury bonds, which you can ladder with no commission.) This leaves us with… surprise… index funds!

So what I should buy?
For some ideas, I recommend looking at the various model portfolios from various respected sources. Most of them have varying mixes of TIPS, short-term, and intermediate bond funds.

As for my own portfolio, I don’t have a large percentage of my portfolio in bonds so just one bond fund will suffice for now. They are in a tax-deferred account, so I won’t need to consider municipal bonds which can have better after-tax yields for those in high income tax brackets.

Since my other investments are already held at Vanguard, I am probably going to choose either the Vanguard Total Bond Market Index Fund (VBMFX, 0.20% ER) or the Vanguard Short-Term Bond Index Fund (VBISX, 0.18% ER). ETF equivalents with 0.11% ERs are BND and BSV. Both have high average credit ratings of AAA. I like the wide diversification of the Total Bond Index, but the average duration is a bit long at 4.5 years. The Short-Term Index fund has a lower 2.4 year duration but is mostly Treasuries and doesn’t have any mortgage-backed bonds. I’ll probably go with VBMFX for now since my time horizon is so long that I am willing too trade a little added risk for a little more return.

I’ve added this post to my Rough Guide to Investing.

Comments

  1. Great post there – since most people have such a small allocation for bonds in their portfolio, they often don’t get enough attention even though choosing the right bond fund can often have a big impact on returns. I agree for a retirement portfolio the total bond index is probably a better choice.

    It’s funny because I always had such a hesitation to put any bonds in my portfolio due to their performance sometimes barely passing inflation. Then I read A Random Walk Down Wall Street and found out that someone who had a decent amount of bonds during the 2000-2002 bear market could have actually come out ahead.

  2. Would it be better to buy bonds from treasury direct instead of a Vanguard Treasury bond fund?

  3. If you are going to sock your money away for 5-7 years in government, municipal or corporate bonds, then you would be better off putting it into a stock market index fund or selecting individual stocks (if you know what you are doing). Here is why.

    Let’s define “real return”. This is the % return on your money after factoring in inflation. Now let’s define “risk”. This is the standard deviation of the returns (sigma). I’ll assume we’re on the same page, as I don’t want to teach a lesson in statistics.

    Historically, over the past 200 years of recorded market action, real stock returns are higher and the standard deviation of those returns are lower than those of bonds, for periods of time greater than 7 years.

    What does this mean? This means better “real” return, and lower volatility (factoring in inflation). This is plainly spelled out in Jeremy Siegel’s book “Stocks for the Long Run”.

    So if you are nearing the end of your retirement, require an extremely dependable paycheck, and don’t mind inflation eating away at your assets, by all means invest in bonds or bond funds. But if you have an investment time horizon of 7 years or longer, then you are really just asking for poor returns no matter what sort of bonds you get into.

  4. nathan in new mexico says:

    Why not go with the ETF version of VBMFX (ticker: BND) as it has an expense ratio of 0.11%? Basically it seems as though Vanguard ETFs offer the low expense ratio of Admiral Shares without the large account balances otherwise required to be eligible for the discount. Trading costs aside (as these can be mitigated by zecco, BofA or Wellsfargo accounts), it appears as though the expense ratios all of Vanguard’s ETFs are lower than their corresponding index fund.

  5. I am also trying to decide which bond fund to use in my IRA. I have 20 years to retirement. What is the reason you would choose the Total Bond or Short-Term Bond fund over the Vanguard Interm-Term Bond Index Fund (VBIIX or the ETF version BIV) ? Is it the time frame of the bond maturity ? I have 20 years to retirement – maybe earlier if I can afford it :-) Thanks!

  6. Bonds are supposed to buy security, and for that, you can’t beat Short Term Government Bonds. Corporate Bonds are bad on many, many levels. For starters, the corporation and bondholders interests aren’t aligned (as is the case with shares of the same corporation’s stock.) They aren’t even that safe (look at Enron’s bondholders).

    What people are trying to achieve with a porfolio of corporate bonds is a little more security than stocks and a little more return than government bonds. Unfortunately, corporate bonds do both of these things poorly.

    A portfolio that takes that corporate bond allocation and instead puts it in a portion in short-term government bonds and a portion in stocks is going to be much better as it gives you the best portfolio tools for accomplishing A: Security and B: Growth.

    Swensen has an entire chapter on this… He in fact says that corporate bonds should not be included in a model portfolio.

    He does make a case for TIPS though…

  7. Jonathan,
    I am not a big city blogger like you but seems like VMMXX is the best bet. 5.12 % yield and not a shred of standard deviation. Both your bond funds have lower yield and higer risk than this.

    Huh. Am I missing something …

  8. “Historically, over the past 200 years of recorded market action, real stock returns are higher and the standard deviation of those returns are lower than those of bonds, for periods of time greater than 7 years.”

    This is absolutely false. While the annualized standard deviations do decrease with time, the total standard deviation increases, which is what matters. For a simple example, the probability of losing 50% or more of your money after 1 year is 70x less than after 3 years. This is true for any sort of “worse case” scenario. This is a very common mistake that almost everyone makes. For more see ch. 8 of the textbook “Investments” by Bodie, Kane, and Marcus.

    For a real exaple, between 1968-1982 stocks lost about 5% in real terms. This is a FIFTEEN year period. With TIPS you can guarantee about a 2% annual real return so this is actually very bad.

  9. “In portfolios, they are usually used to reduce the overall volatility because of their low correlation with stocks. When stocks go one way, bonds tend more to go the other (thought not always).”

    This point needs some clarification. A low correlation means that bonds move independently of stocks. One does not go up because the other goes down. They can both go up today and down tomorrow.

    Stocks and bonds both have risks, but because those risks are (mostly) separate and unique, you achieve an overall lower volatility. The old “don’t put all your eggs in one basket” bit.

  10. CD_Vision says:

    No no, the reason you need to have bond investments is not because the price of the bonds doesn’t fall when stocks do, it’s because the yield is consistent and reliable, you know exactly what your return will be over the lifetime of owning them.

    What you should do is keep at least 25% of your money in a bond fund, and if the stock market takes a dive, use some of that money to rebalance your accounts at and buy more stocks. Eventually the stocks will come back up, and you’ll have a fat gain. Likewise, if the stock market is doing well, take some of those gains and buy bonds to maintain the percentage. This is the real reason bonds are good, because they protect you from market crashes.

  11. “I am not a big city blogger like you but seems like VMMXX is the best bet. 5.12 % yield and not a shred of standard deviation. Both your bond funds have lower yield and higer risk than this. Huh. Am I missing something ?”

    Yes. You’ve missed the little disclaimer on the bottom of every financial website. Past performance does not guarantee future results. Right now, cash is beating bonds — and many stock funds too. The question is the same as always: How long will that continue?

  12. Wait! Everyone seems to have missed my point–bond returns are *not* 100% reliable, consistent, or dependable. That is, their artificial return (i.e. 5%) might be, but their real return after inflation can, and has, varied wildly due to inflation.

    With very a very typical inflation of 3.5%, your 5% bond index is only yielding 1.5% “real” return. A spike in inflation, as happens periodically, and you will be losing money. Because stocks represent underlying, real businessesor assets, they tend to me more resistant to long term inflation pressure, and thus yield higher “real” returns with less volatility over longer periods of time.

    Cheers.

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