Vanguard Bond Funds Are Not All Created Equal

Whenever interest rates are low, many investors make the mistake of reaching for incremental yields. As noted back in February, a popular choice for reaching for yield involves investing in the Vanguard Total Bond Market Fund (VBMFX). When we last looked at the fund, it held about $70 billion of assets. The fund's popularity hasn't waned, as it now hold almost $90 billion. The question is: Does the fund deserve the attention? Or, is there a better alternative?

The attraction of VBMFX is the higher yield it carries compared to the similar Vanguard Intermediate-Term Treasury Fund (VFITX). The higher yield is the result of the credit and call risks from corporate bonds the fund holds and the optionality (creating uncertain maturity) in the mortgage-backed securities it holds.

Despite the higher yields, VBMFX underperformed VFITX 6.4 percent versus 6.8 percent for the period January 1992 (the start of the first calendar year for the VFITX) through June 2010. However, it did experience lower volatility, producing a standard deviation of 3.9 percent versus 5.8 for VFITX.

As readers of my books and this blog know, you shouldn't make the mistake of thinking of investments in isolation. So let's see how the two funds mixed with equities in a 60/40 portfolio, rebalanced quarterly. For equities, we'll use the Vanguard 500 Index Fund (VFINX):

• The portfolio containing VBMFX had an annualized return of 7.3 percent with a standard deviation of 9.6 percent.
• The portfolio containing VFITX had an annualized return of 7.6 percent with a standard deviation of 9.0 percent.

It's also important to note that the portfolio with VBMFX experienced larger losses in the worst periods, an issue especially important for investors in the withdrawal stage. For example, in 2008 the portfolio with VBMFX lost 20.2 percent, 3.3 percent worse than the 16.9 percent loss experienced by the portfolio with VFITX. For 2002, the figures are losses of 10.0 percent for the portfolio with VBMFX versus a loss of 7.6 percent for the portfolio with VFITX. This demonstrates that the risks of corporate bonds and mortgage-backed securities do not mix as well with the risks of equities as do the risks of Treasuries.

Repeating the lessons from our prior post:

• You shouldn't confuse yield and return.
• You don't need to stray beyond the safest and simplest fixed income investments to achieve your goals. In fact, the evidence suggests you shouldn't. If you need more return from your portfolio, you should take the risks on the equity side where they have been better rewarded.