A reader writes in, asking:
“One of the fund choices in my 401K is Bond Fund of America (RBFCX). It has a much lower yield than Vanguard’s Total Bond Market Index Fund: 0.98% vs. 1.57%. With bonds, low yield should mean low risk. But based on the descriptions of the two funds, I don’t see why Bond Fund of America would have less risk.”
Fund names and fund descriptions can be misleading. I think the best way to assess a fund’s risk level is to actually take a look at what’s inside. Typically, that means going to Morningstar.
For a bond fund, I click over to the “portfolio” tab on the fund’s Morningstar page and look at two important pieces of information:
- Average duration, and
- Composition of the holdings with regard to credit quality.
In terms of interest rate risk, Bond Fund of America is slightly safer than the Vanguard Total Bond fund, with an average duration of 4.55 years rather than 5.18 years. But from the credit quality perspective, Bond Fund of America is somewhat riskier, mostly due to having a significantly smaller allocation to Treasury bonds than Vanguard Total Bond has (~17% rather than ~37%).
Looking at Pictures
While I’m not one for comparing performance for the sake of picking the higher-performing fund, I do think past performance can be useful for getting an idea of how risky a fund is. One of my favorite ways to do this is to plot a fund’s performance against the performance of a fund I’m more familiar with (e.g., comparing a U.S. stock fund to Vanguard’s Total Stock Market Index Fund).
The following Morningstar chart (click to enlarge) shows the last 10 years of performance for Bond Fund of America (in blue) as compared to Vanguard Total Bond Market Index Fund (in orange).
In short, while these funds are at least in the same general ballpark in terms of degrees of risk (e.g., much less risky than a stock fund), the American Funds fund does appear to have somewhat greater overall risk due to its lower average credit quality.
SEC Yield: After Expenses
So, if the Vanguard fund has slightly less risky bonds, why does it have a higher yield?
A fund’s SEC yield is calculated on an after-expense basis. This is why, for example, if you compare the SEC yield on the Investor Shares and Admiral Shares versions of a given Vanguard fund, you’ll see that they differ by an amount equal to the difference in expense ratios.
The R3 share class of Bond Fund of America that this reader has in his 401(k) has an expense ratio of 0.92%. In contrast, Vanguard Total Bond Market Index Fund’s expense ratio is just 0.10% (for Admiral shares). If the two funds’ holdings were exactly the same, the difference in expense ratios would give the Vanguard fund an SEC yield that’s 0.82% higher than the yield of the American Funds fund.