By James M Dahle, MD, Emergency Physician, WCI Founder
Most of the time on this blog we talk about stuff that really matters—things like your income, your savings rate, and your overall asset allocation. However, occasionally we get into the weeds and talk about stuff that only matters a little, if at all. And maybe doesn’t even have a correct answer. Today is one of those days. We’re going to talk about what bond fund or funds you should hold in your portfolio.
Should You Hold a Bond Fund?
There are two prerequisite issues we need to get out of the way before we get started. The first is whether you should hold bonds at all. We’re not going to discuss that today, but if you are unclear on this issue, I would recommend these posts:
The second issue to address is whether or not you should use a bond fund at all. I think bond mutual funds are a great way to own bonds. They provide:
- Professional management
- Daily liquidity
- Massive bond diversification
- Economy of costs
However, there is an alternative. You can simply own the individual bonds (or CDs) yourself. Some people like to do this because it guarantees (at least as much as whoever is backing the bond can guarantee it) that when the bond matures you will get back all of your principal and all of the interest due, at least in nominal terms. I generally think this is a terrible idea for corporate bonds and a bad idea for municipal bonds. Diversification and liquidity in both of these categories is well worth the additional (but still trivial) cost of a good bond fund. With treasury bonds a better argument can be made to purchase them individually, particularly if you are buying them in a taxable account directly without fees from TreasuryDirect. However, that’s a pretty tiny percentage of investors who want to buy individual treasuries and want to buy them in a taxable account.
So before we move on, let’s assume that you, like me, actually want to own bonds and actually want to own them in the form of a bond fund.
Do Bonds Belong in Taxable Accounts or Retirement Accounts?
The next issue that should be addressed is “What type of account will your bond fund be held in?” If you are going to hold your bond fund in your employer’s 401(k), 403(b), or 457(b), you are going to be limited to whatever they offer in that account. Some unique employer retirement plans even have unique bond funds options that you cannot get anywhere else, such as the TSP G Fund. An IRA will give you more options, of course. If you are going to hold your bonds in a taxable account, and you are in one of the upper tax brackets, you probably want to give very serious consideration to having a large chunk (if not all) of those bonds be in a municipal bond fund—preferably one that focuses on bonds in your own state. Remember the yield of municipal bonds is federal tax-free, and if the bonds are from your state, state tax-free. If you need help deciding where to hold your bonds, I recommend this post about Asset Location. The classic teaching is bonds go in tax-protected accounts whenever possible, but at low interest rates like we have right now, it doesn’t matter much and can even be better to have them in taxable.
Where Will You Take Your Risk?
Another important decision, this one more philosophical, is “Where in your portfolio are you going to take your risk?” There are basically two schools of thought here. The first is that you should take your risk on the equity side. Believers in this school of thought prefer to stick with very safe bonds in the portfolio. They may have fewer of them, or they may use a more risky asset allocation on the equity side (such as a small value tilt) to make up for it. The other school of thought is that it is okay to take some risk on the bond side too, particularly in tax-protected accounts. When choosing which bond fund(s) to use, you will need to decide how you feel about this issue. Those who fall in the first camp tend to have primarily short-term treasury and muni bonds in their portfolios. Those who fall in the second camp tend to have longer-term corporates in their portfolios, or sometimes more exotic types of fixed income like Peer-to-Peer Loans or Real Estate Debt Investments. “Risk Parity” believers are into long-term treasury bonds, although I suspect a lot of their theory relies on back-tested data from a period of time when long term bonds did particularly well. I admit my own ambivalence on the topic, which tends to be reflected in my portfolio (where I invest in pretty safe bonds, but also put 5% of my portfolio into real estate lending funds). Remember there are basically two risks in the bond world:
- Interest rate risk and
- Default risk
Interest rate risk shows up when interest rates rise, causing a drop in the value of a bond with a now lower yield than what is available on the open market at the new higher interest rate. Interest rates and bond prices are inversely correlated. Default risk shows up when a bond issuer stops making payments, or at least looks like they may stop making payments.
Traditional Funds or ETFs
Another relatively minor issue to be aware of is a problem that some bond ETFs have that traditional bond funds do not have. Basically, individual bonds (at least corporates and munis) are much less liquid than individual stocks, so the ETF creation/destruction method may not work as well as it does with stocks during a liquidity crisis. More information in this post:
Best Bond Funds
Now that we’ve got the preliminary issues out of the way, let’s address the point of this post—which bond fund should you actually use?
Total Bond Market
Many portfolios use a Total Bond Market Fund. This is actually terribly misnamed. While it does basically include all corporate bonds, nominal treasury bonds, and mortgage-backed (GNMA) bonds in the US, consider all of the bonds it does not include:
- International Bonds
- Municipal Bonds
- Junk Bonds
- Savings Bonds
If you really want a “total bond market portfolio” you’ll need to own 3-5 more bond funds!
Consider the statistics (taken in July 2021) and the style box:
- Yield: 1.32%
- Duration: 6.8 years
- # of bonds: 10,138
- Expense ratio: 0.05% Vanguard Admiral, 0.035% Vanguard ETF, 0.025% FXNAX, 0.04% SWAGX, 0.06% IUSB
I think there are two key statistics to key in on here. The first is the average duration, 6.8 years. That means if interest rates suddenly rise 1%, you’ll lose about 6.8% of your investment. Of course, you’ll then have a higher yield (and thus a higher expected return going forward) and you will actually be ahead due to that higher yield after 6.7 years. The other important thing here is to see what the fund is actually invested in: 42% treasuries, 24% mortgages, and the rest (34%) in some type of corporate bonds. You’re basically hedging your bets by owning all three of these types of bonds. This is an important fund to understand as it is so widely used. All of the “3 fund portfolio” fanatics use it. It is usually available in some form in any halfway decent 401(k) or 403(b). This is basically what the TSP F Fund is. I prefer the Vanguard admiral version, but the others listed above are perfectly fine funds.
Vanguard Intermediate Index Fund
However, when I designed my parents’ portfolio 15 years ago, I didn’t use the Total Bond Market Fund. I used a similar, but different, fund—the Vanguard Intermediate Index Fund. It avoids the mortgage bonds (GNMAs). The statistics look like this:
- Yield: 1.6%
- Duration: 6.6 years
- # of bonds: 2129
- Expense ratio: 0.07% Vanguard Admiral, 0.05% Vanguard ETF
Although the fund used to have a slightly higher yield and slightly higher duration than the total bond market fund, it is now very similar on both counts. The only difference is there are no mortgage-backed securities (GNMAs) in it. That means fewer bonds and less diversification. The argument against GNMAs is that when interest rates go up, you take a big hit in value (like any bond) and when interest rates go down, the borrowers refinance (pre-paying their mortgages) so you don’t benefit like you would with a non-callable bond. Of course, when interest rates stay the same, GNMAs work out better since they generally have higher yields (currently 1.6% with a duration of only 2.3 years) than a treasury bond.
Basically, if you hate GNMAs, use the Vanguard Intermediate Index Fund. If you like GNMAs, use a Total Bond Market Index fund. If you love GNMAs, use the Vanguard GNMA Fund. So did I make the right decision using the intermediate fund over a TBM fund? Apparently, I did. Annualized returns over the last 10 years were 4.23% versus 3.36%. Whether that outperformance will continue going forward is anybody’s guess and largely depends on the performance of mortgage-backed bonds (which only made 2.65% over the last 10 years).
Other Bond Options
There are dozens of other options out there as well. They’re all even less diversified than the above two options. You can take on more default risk by using solely corporate or even junk bonds in your portfolio.
Vanguard Intermediate Corporate Bond Index Fund
- Yield: 2.0%
- Duration: 6.5 years
- # of bonds: 2083
- Expense ratio: 0.07% Vanguard Admiral, 0.05% Vanguard ETF
Vanguard High Yield Corporate Fund
- Yield: 3.7%
- Duration: 3.6 years
- # of bonds: 605
- Expense ratio: 0.13% Vanguard Admiral
The upside is higher yields, the downside is that in an equity downturn, these bonds are likely to underperform treasuries, particularly the junk bond fund as defaults rise. You can do just the opposite and just use treasury bonds.
Vanguard Intermediate Treasury Index Fund
- Yield: 1.0%
- Duration: 5.4 years
- # of bonds: 112
- Expense ratio: 0.07% Vanguard Admiral, 0.05% Vanguard ETF
If you want to take on more term risk, you have options in each of these categories:
- Vanguard Long Term Bond Index Fund
- Vanguard Long Term Corporate Bond Index Fund
- Vanguard Long Term Treasury Bond Index Fund
If you want to take on less term risk, you again have options in each of these categories:
- Vanguard Short Term Bond Index Fund
- Vanguard Short Term Corporate Bond Index Fund
- Vanguard Short Term Treasury Bond Index Fund
It’s hard to choose without a working crystal ball, and that’s why most people end up with one of the first two funds I mentioned for their nominal bond allocation.
Municipal Bond Fund Options
If you are in a high tax bracket and have any significant part of your bond holdings in your taxable account as I do, you should take a look at Vanguard’s excellent municipal bond funds. Pre-tax yields are obviously lower when you compare to a taxable bond fund, but the after-tax yield is usually higher for high earners. For example, I use the intermediate-term fund.
Vanguard Intermediate-Term Tax-Exempt Fund
- Yield: 0.9% (equivalent after-tax yield in the 37% bracket = 0.9%/(1-37%) = 1.43%)
- Duration: 4.3 years
- # of bonds: 12,431
- Expense ratio: 0.09% Vanguard Admiral
Lots of other options in the tax-exempt space too. If you live in California, Massachusetts, New Jersey, New York, or Pennsylvania, Vanguard has a fund just for you that will also be exempt from state taxes. If you want a longer duration, they have the Long Term Tax-Exempt Fund (duration 5.1 years). If you prefer a shorter duration, they have the Limited-Term Tax-Exempt Fund (duration 2.3 years). If that’s not short enough for you, try the Short Term Tax-Exempt Fund (duration 1.0 years) or even the Municipal Money Market Fund (average maturity of 12 days). There’s also a high-yield (junk) option, the Vanguard High-Yield Tax-Exempt Fund (yield 1.6%).
Inflation-Adjusted Bond Options
Most inflation-adjusted bond funds just invest in Treasury Inflation-Protected Securities (TIPS). Vanguard offers two options here. The first is the 20-year-old Inflation-Protected Securities Fund. Note that the admiral shares version of this fund requires a $50,000 minimum investment, not just the usual $3,000 investment and that the yields are REAL (after-inflation) yields, not nominal yields like all the bonds above.
- Yield: -1.69%
- Duration: 7.2 years
- # of bonds: 47
- Expense ratio: 0.10% Vanguard Admiral
If you don’t like all that term risk, consider the Short Term Inflation-Protected Securities Index Fund (also available as an ETF). The minimum investment for admiral shares is only $3,000, the expense ratio is slightly lower, and the duration is only 2.5 years. The downside? A lower yield, at -1.59% real.
I Bonds (a type of savings bond) may be a good option for you. They’re also protected from inflation and are currently paying 1.68% (nominal). That yield is comprised of a 0% fixed yield plus the 1.68% inflation rate. Beats the current EE bond rate of 0.10% (nominal), but those are guaranteed to at least double over 20 years (3.53% nominal). Unfortunately, those bonds really aren’t practical for those with large bond portfolios built over just a few years.
International Bond Options
Vanguard currently offers four international bond funds. Its largest fund is the Total International Bond Market Index Fund.
- Yield: 0.6%
- Duration: 8.4 years
- # of bonds: 6,294
- Expense ratio: 0.11% Vanguard Admiral, 0.08% Vanguard ETF
It’s pretty hard to get excited about the combination of a duration of 8.4 years and a yield of just 0.6%. Vanguard also has two emerging markets bond funds, one actively managed and one index.
The newest Vanguard International bond fund is the Global Credit Bond Fund, an actively managed fund that invests in corporate bonds in both the US and overseas. Technically, that’s a “Global” (includes US) fund, not an “international” (excludes US) fund.
The Bottom Line
As you can see, there are a plethora of options and that’s just at Vanguard. If your crystal ball is cloudy about the future, I would suggest choosing either the Total Bond Market Fund or the Intermediate Index Fund if you are investing in a tax-protected account and the Intermediate-term Tax-exempt Fund in a taxable account. If your crystal ball is not cloudy and you wish to bet on outperformance of some aspect of the bond market, then adjust term and default risk to your taste.
If you wish to diversify into inflation-indexed bonds, either of Vanguard’s options are great as are IBonds if you can purchase a meaningful amount of them. If you invest through another brokerage, be aware that Fidelity has a good TIPS fund and both Schwab and iShares have good TIPS ETFs.
If you wish to diversify into international bonds, I would stick with the plain vanilla Total International Bond Market Fund because strange things can happen with loans to emerging market governments (see Argentina and Russia for details). Personally, I don’t invest in international bonds. I’m willing to give up that diversification in order to reduce portfolio complexity.
In my own portfolio, I split my bonds 50/50 nominal/inflation-indexed and my current holdings (remember bonds are 20% of my portfolio) are:
- 4% TSP G Fund
- 6% Vanguard Intermediate-term Tax-exempt Fund
- 10% Schwab TIPS ETF
What do you think? If you invest in bonds, what funds do you use and why? Comment below!
Originally posted at https://www.whitecoatinvestor.com/bond-funds/