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.

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.

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