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.”
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 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.