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Total Bond Market Fund vs. Treasury Bonds

As I mentioned recently, the bond portion of my own portfolio consists of a Treasury bond fund rather than Vanguard’s Total Bond Market fund. That choice drew questions from several readers.

For the record, I do not think there’s anything wrong with using Vanguard’s Total Bond fund. It’s a super low-cost fund that does a fine job of reducing the risk of an otherwise-equity portfolio. In other words, I think you can safely file this under the heading of “not likely to make or break your retirement plans either way.”

Still, many people asked for my reasoning, so here goes.

What’s the Difference?

The expense ratios are essentially the same, so the only meaningful difference between the funds is what bonds each one holds. According to Vanguard’s site, the Total Bond fund is made up approximately as follows:

  • 43% Treasury bonds,
  • 28% government mortgage-backed securities,
  • 24% corporate bonds, and
  • 5% foreign bonds

In contrast, a Treasury bond fund is made up exclusively of Treasuries (of varying maturities depending upon which Treasury fund you choose). So the primary question is this: Do you want mortgage backed securities and corporate bonds in your portfolio?

For me, the answer is “not particularly.”

Corporate Bonds

I don’t place a ton of faith in historical statistics about returns, and that includes historical data about correlations. However, I think one thing that we can assume will often be true is this: Stocks will usually be more highly correlated to corporate bonds than to Treasury bonds.

There’s a very common-sense reason for it: When the economy and stock market are doing poorly and companies are struggling, more companies than usual will be seeing their credit ratings downgraded. Result: Those companies’ bond prices go down at the same time their stock prices go down.

In my portfolio, the role of the bond allocation is to reduce the portfolio’s overall volatility. And since I have a very stock-heavy allocation, the low correlation that Treasuries have to stocks makes them quite good at performing that role–better than corporate bonds, in my opinion.

Mortgage-Backed Securities

Mortgage-backed securities are essentially bonds made up of a tiny slice of numerous different mortgages. Government mortgage-backed securities (like those included in Vanguard’s Total Bond fund), are backed by the Federal government, so they have no credit risk.

Mortgage-backed securities do, however, carry a risk that Treasury bonds do not: prepayment risk.

To explain, consider a mortgage from the perspective of a homeowner. If you have a high-rate mortgage and market interest rates go down, what do you do? You refinance.

So from the perspective of the bond-holder, you don’t actually know what the maturity of your mortgage-backed security will be (because when any of the underlying mortgages are prepaid, you get some of your cash back early). And, unfortunately, mortgage-backed securities tend to be prepaid the most at exactly the worst time: When interest rates are lowest.

This prepayment risk would not necessarily be a concern if mortgage-backed securities tended to earn higher returns to compensate for it. But, as Larry Swedroe has pointed out, that has not been the case historically.

Should I Avoid Vanguard’s Total Bond Fund?

Despite the above arguments, I can’t state strongly enough that of all the bond funds out there, Vanguard’s Total Bond Market Index Fund is one of the very best. It’s a super-cheap bond fund consisting mostly of Treasuries and government-backed bonds, and it has no management risk. In my book, that’s not bad.

For example, if you have access to Vanguard’s Total Bond fund in your 401(k), consider yourself lucky.

Or, if you’re an investor who finds the idea of a target retirement fund appealing, the fact that Vanguard’s target funds use the Total Bond Market fund as opposed to a Treasury fund would not give me any hesitation whatsoever about recommending them.

I’m happy to exclude government mortgage-backed securities and corporate bonds from my portfolio because doing so doesn’t introduce any additional complexity or increase my expenses at all. If that were not the case, I wouldn’t really mind including them.

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Comments

  1. I always thought TBM was the instrument of choice because if offered so much diversity, but I see your logic. So if I understand you correctly: as far as correlation is concerned, owning corporate bonds is for all intents and purposes equivalent to owning more stocks. I hadn’t been aware of the pre-payment issue, but it seems to be a good argument for not having GNMAs. And I take it you are going short with bonds because of interest rates, and not including TIPS at present until you get closer to retirement. Additional question: how do you feel about municipals?

  2. I wouldn’t say owning corporate bonds is equivalent, per se, to owning more stocks. They’re still bonds, after all. But, yes, corporate bonds have historically had higher correlation to stock returns than Treasury bonds have. And it seems reasonable to me to expect that to be the case in the future as well.

    Yes, my use of the ST Treasury fund as opposed to the intermediate one is a function of current low interest rates. The next few times I make contributions, if rates have gone up meaningfully, I’ll probably switch back to the intermediate fund.

    To be clear though, I’m far from 100% confident that this strategy will work out advantageously. Rather, I’m pretty confident that it won’t make a huge difference either way. (It’s only 10% of my total portfolio, and I’d be perfectly happy to hold ST Treasuries for the long-haul if that ends up being the result.)

    Yes, I expect to move more heavily into TIPS as retirement nears. At the moment though, I’m not particularly exposed to inflation risk–perhaps even less exposed than most people with jobs, as I have the ability to set my own prices.

    As a general rule, I think tax-free bonds make a lot of sense in taxable accounts if your tax bracket is high enough that you’d be able to get a significantly higher yield. They do have credit risk, however, so there does need to be a higher yield in order for it just to be a break-even decision.

    Given a very large portfolio, I see some sense in hand-selecting a collection of muni bonds (rather than using a fund) and sticking exclusively with those of the highest credit rating.

  3. Thanks. I would assume, however, that it makes little sense to hold municipals within a tax-deferred account, as you’re taking something that is actually tax free and then having to pay ordinary tax on it when you withdraw it from the IRA.

  4. Correct. There’s no reason to hold muni-bonds in a tax-sheltered account when you could use Treasuries instead–thereby reducing credit risk and increasing yield at the same time.

  5. As it happens, I currently have about 10% of my portfolio in the Spartan short-term treasury index fund, which holds Treasuries with 3-5 year maturities. But I’ve been losing money recently as yields increase. Every day it seems I see articles advising me to get out of bonds and especially Treasuries, as everyone seems convinced that yields can only go up. Yours is one of the few opinions I can find that seems to favor sticking with such a fund but I want to check to make sure I’ve understood your position correctly. Would you stay in a 3-5 year duration Treasury index fund even though rising yields seem to be inevitable?

  6. Hi Florence.

    Just to be clear: Are you asking about holding short-term Treasuries as opposed to holding Treasuries of other maturities? Or holding ST Treasuries as opposed to holding other types of bonds or stocks?

  7. I have Vanguard’s Total Bond Market fund, and over the last couple of year’s its worked out okay for me in terms of total return (div + cap gain). But it is only 10% of my portfolio and does provie an easy and low cost way of maintaing my bond exposure. Great analysis you have here.

  8. Hi Mike,
    I have no intermediate or long-term bonds. Just the short-term Treasuries (average duration 3 years) representing about 10% of my portfolio and maybe 1/3 of that in an index fund that tracks short-term bonds. FYI, I’m getting close to retirement.
    F

  9. PS: Thanks so much for taking an interest!

  10. Florence, here’s my take on the situation:

    First, I have absolutely no predictive power with regard to where interest rates are heading in the near future. So I try to make all my decisions with that in mind.

    If interest rates do rise, then yes, bond prices will fall. However, it’s worth noting that:

    • The shorter the maturity of the bond, the less its price will fall. (This is why I’ve opted to use ST bonds myself for the time being.)
    • All types of bonds will fall in price when interest rates rise, not just Treasuries.

    With an average duration of 3 years, even if interest rates rise, you’re not really facing a catastrophe. For example, if rates went up 3%, your ST Treasuries’ price would decline by about 9%–not wonderful, but nothing like the declines stocks go through sometimes. Also, if you can wait until maturity, you’ll get the full face value back regardless.

    In other words, yes, the price of Treasuries will decline if rates go up. But if volatility is what you’re concerned with, there isn’t really a better alternative (aside from cash, perhaps). Moving money out of ST Treasuries and into longer term Treasuries, bonds with more credit risk, or stocks aren’t exactly ways to reduce risk.

  11. Once again, Mike, thanks so much for taking the time to respond to my question. Your comment about how rising interest rates would affect a short-term bond fund (i.e. not much) did help to put things in perspective. Your approach makes complete sense for anyone who is either unsure of whether interest rates are heading and/or committed to a fairly strict “no market timing” approach to investing.

    However, as you say, cash *is* an alternative to bonds. And if you think there’s a high likelihood of rising interest rates it seems to me that cash in the form of laddered CDs or even a high-interest saving account starts to look attractive. Another alternative to a bond fund would be to buy individual bonds, as there you get protection of principal and a guaranteed return. But you don’t get that with a fund, do you?

  12. “Another alternative to a bond fund would be to buy individual bonds, as there you get protection of principal and a guaranteed return. But you don’t get that with a fund, do you?”

    Well, you kinda-sorta do with a short-term fund. For example, if your bond fund’s longest-maturity bond is 4 years out, after 4 years, all of the bonds will have matured and their principal will have been repaid (assuming no defaults, which is a safe assumption in a Treasury fund).

    Of course, more bonds will have been purchased during that time frame. But they will have been purchased earning the new, higher market interest rates.

    All of that said, yes, cash/savings is a safe place to put your money if you expect rates to rise and you’re seeking to avoid the resultant temporary decline in ST bond prices.

  13. It’s interesting that Suze Orman, after giving sound advice on stock index funds, expresses a horror of bond funds (she’s kind of verbose, so you’ve got to scroll and scroll to the bond fund section):

    http://au.pfinance.yahoo.com/b/moneymatters/23/mutual-funds-for-the-rest-of-us

    I can see already she’s wrong about expense ratios (at least where Vanguard and Fidelity Spartan come in), but do you buy the rest of her argument?

  14. Well, she overstates the expenses you’re likely to pay with a fund. There’s just no need to pay 1% per year.

    She’s right that you lose the certainty that comes with buying a bond and holding it to maturity. (Exception being short-term funds as discussed in my reply to Florence, wherein the bonds are often held to maturity, thereby providing not exactly the same degree of certainty that individual bonds provide, but something kind of close to it.)

    Depending on what role your bond holdings play, however, that’s not necessarily a big deal.

    In some cases, buying a bond and holding it to maturity is the perfect fit. For instance, if you know you plan to buy a second home in 10 years, a 10-year TIPS is a great match for that need.

    On the other hand, if you don’t know at what point you’re going to be selling, then there’s no way to match the bond’s maturity to your spending time frame anyway. That’s the case in my own portfolio, for example, in which the only time I sell bond holdings is when I need to rebalance out of bonds and into stocks–and I have no way of predicting when such instances will occur.

    For a retirement portfolio, if there was a way to build a ladder of TIPS in which some mature every year, that would match spending needs pretty well. Unfortunately, you can’t exactly do that, because there would be many gaps in the ladder.

    In addition, I always think there’s something to be said for the simplicity of having one holding in each bond category (a fund) rather than several holdings (a ladder) in each category.

  15. Mike, are you aware of this site: http://www.assetcorrelation.com/

    It was instructive to me to see the pattern of correlations between markets, and market sectors.

  16. Nope, hadn’t seen that one yet. Neat idea.

    That said, I must admit that with a maximum period of two years for the correlation matrices (unless I’m missing something?) I’m reluctant to put much faith in the predictive value of the data at all.

  17. Hi Mike,
    I am confused w/ regard to choosing either the Vanguard Intermediate-Term Treasury Fund (VFITX) or the Vanguard Total Bond Market Index Fund (VBMFX). Looking at the performance the treasury fund comes out better than the total bond market index. I just got off the phone with with my Vanguard Fianancial Plan Advisor ( I paid to them draft a plan for us) and he to was recommneding the total bond market index for the bond portion of our portfolio. Logic was more risk, more volatility but better yield potential for the total bond market index. Yet when I look at the historic performance of each the Intermediate-Term Treasury Fund comes out better. So why would you ever choose the Total Bond Market Index Fund when you are getting more risk with no better long term return and expenses are about the same? Or is that your point. :-)

    Happy trails, Capt. Mike

  18. Hi Mike.

    Because of its higher risk, TBM does have higher expected return than the intermediate-term Treasury fund. But of course the higher return might not actually show up in any given period.

    It’s very analogous to the way that stocks have higher expected returns than bonds. But in any particular period (especially shorter ones) there’s a decent chance that bonds will outperform stocks.

  19. Thanks Mike. So what would be the factors to consider when deciding between Vanguard Short Term Treasury fund and Intermediate Term Treasury fund?
    Capt. Mike

  20. Well, the longer the maturity, the more interest rate risk there is. (That is, the more the price of the fund will fluctuate when rates go up or down.)

    So the intermediate-term fund will be somewhat higher risk, higher yield.

    There’s nothing wrong with either fund. In my opinion, they’re 2 of my 3 top choices for the bond portion of a portfolio. (Vanguard’s TIPS fund being the other top choice, depending on circumstances.)

If you want to discuss this article, I recommend starting a conversation over at the Bogleheads investing forum.
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