Archives for July 2024

One of the most common questions I see in my email inbox, on the Bogleheads forum, and on Bogleheads reddit is something along these lines:

“I bought Vanguard Total Bond Market Index Fund (or ETF) as my core bond holding several years ago. Its performance has been enthusiastically lackluster. Is this fund still suitable for use as the bond part of my portfolio?”

Vanguard Total Bond Market ETF (BND) has had a roughly 16% cumulative return over the last 10 years (annualized return of 1.5%). Given 32% cumulative inflation (2.82% annualized) over the same period, that’s not great. And compared to the mind-blowing 222% cumulative (12.43% annualized) return that Vanguard Total Stock Market ETF has provided over the last 10 years, it does indeed feel very lackluster.

But it’s not as if this unimpressive performance is the fund’s fault. Per Morningstar, it has been in the top half of funds in its category over the period in question. In other words, the fund has been managed just fine.

And it’s not as if “total bond” funds have been particularly bad. It’s been an uninspiring period for basically any type of bond fund. For instance:

• Vanguard Short-Term Treasury Fund (lower risk than a “total bond” fund) has had an annualized return of 1.05% over the last 10 years.
• Vanguard Intermediate-Term Treasury Fund (lower risk than a total bond fund but higher risk than a short-term Treasury fund) has had an annualized return of 1.26% over the last 10 years.
• Vanguard Intermediate-Term Investment Grade Fund (higher risk than a total bond fund) has had an annualized return of 2.49% over the last 10 years.

Why have bond funds struggled?

Bond funds have struggled simply because interest rates went up. For any given bond, when market interest rates for similar bonds rise by a given percentage, the price of that bond will fall by approximately the bond’s duration multiplied by the increase in interest rates.

Interest rates for intermediate-term bonds have risen by about 2% (for both Treasury bonds and investment-grade corporate bonds) over the last 10 years. Vanguard Total Bond Market has an average duration of about 6 years. So, for a fund with an average duration of 6 years, a 2% increase in rates means that the decline in price gobbled up roughly 12% -worth of return. And interest rates were fairly low to begin with (about 2.2% for 7-year Treasury bonds as of July 2014), so that rising-rates headwind was quite a hurdle to overcome.

In other words, bonds did what they do, in a period of rising rates. Nothing particularly strange about this. It admittedly doesn’t feel great, compared to the inflation we’ve had and compared to the superstar returns that we would have earned if the money we’d had invested in bonds would have been invested in stocks instead. But it’s not as if “bond funds are broken” or “bonds are obsolete” or anything like that.

Looking Forward

A total bond fund is still a very reasonable core bond holding, in my opinion — as would be a short-term Treasury fund, intermediate-term Treasury fund, short or intermediate-term TIPS fund, collection of individual CDs, or a ladder of individual TIPS.

There many different reasonable choices. If you want to have a specific amount of purchasing power available on a specific date, you need individual TIPS, held to maturity (or I-Bonds). But for anybody who just wants bonds to be “the thing in the portfolio that’s less risky than stocks, while still providing some return,” then any reasonably low-risk, low-cost bond fund would be acceptable.

I don’t believe there’s any magic in asset allocation, and that’s as applicable with bonds as it is with stocks. Riskier bonds tend to be rewarded with higher returns over time. The safer you want your bonds to be, the less return they’ll probably give you over time.

Right now, we have an “inverted yield curve” (meaning shorter-term bonds actually have higher yields than longer-term bonds). That’s uncommon because short-term bonds are lower-risk than long-term bonds. It may look like a free lunch (i.e., higher yields with lower risk), but really it’s the bond market’s way of saying “we expect interest rates to fall.” That is, right now, the market sees longer-term bonds as an opportunity to lock in unusually high interest rates, whereas shorter-term bonds give you higher rates for now but with the risk that you’ll be earning lower yields again soon if interest rates fall.

What actually will happen with interest rates going forward? I have no idea. That’s why I still think both short-term or intermediate-term bond funds are a reasonable choice. Or long-term TIPS if held to maturity.

A reader writes in, asking:

“I am curious for your take on the age-in-bonds rule of asset allocation. It seems to me that maybe it’s a bit out of date, and today higher stock allocations are called for.”

I have never particularly been a fan of the “age in bonds” rule. But that’s not because I think that it needs to be adjusted to “age minus 20” or anything like that. Rather, I think that age is simply not a very good stand-in for risk tolerance.

For example: consider my wife and me. When we were 25, our incomes were pretty modest. Our assets were very modest. Our Roth IRAs were definitely not intended to function as emergency funds, but it wasn’t at all out of the question that if a large unexpected expense came up, that’s where we’d be going for the cash necessary to pay the bill. It would have been either raid the Roth IRAs or put it on a credit card. Point being, despite being young, we simply had a limited financial ability to take on risk.

Today, we’re both age 40. And there’s no question that our ability to take risk is greater than it was at age 25. We’re still far enough from retiring that a market decline wouldn’t throw off our plans in any meaningful way. We now have considerably higher household income. After 15 more years of saving and investment returns our assets are dramatically greater than they were at that time. And now the portfolio isn’t doing double-duty as an emergency fund in the way that it was at age 25. We are now more financially secure in every way.

15 years older, but with much greater ability to take on risk in the portfolio. And there’s nothing remotely weird about that set of circumstances. That is in fact the normal path for a household’s finances to take, over that particular age range.

Or consider this example: Jimmy and Bob are two unmarried retirees, who have completely identical finances (identical portfolios, identical Social Security income, both spending let’s say 4% from the portfolio per year, etc.). The only difference is that Jimmy is age 65 while Bob is age 95.

Bob has a greater ability to take on risk than Jimmy does. At age 65, Jimmy’s portfolio is still overwhelmingly a retirement portfolio (i.e., intended largely for the purpose of funding his own spending during retirement). For Bob at age 95 with a 4% spending rate, there’s functionally zero chance of running out of money during his lifetime; a large portion of his portfolio is now a bequest portfolio.

Again, the older person has a greater ability to take on risk. And again, there’s nothing particularly weird/unusual about that hypothetical. It’s not rare for it to become clear at some point that the portfolio is, to a significant extent, now being invested on behalf of one’s intended heirs rather than on behalf of one’s own self.

All of this isn’t to say that the ability to take risk always goes up with age, because that’s definitely not true either. Rather, there are specific times in a person’s life where a risky portfolio is simply more dangerous, such as:

• Very early in the career when the portfolio is also the emergency fund and income/assets are very limited, and
• In the few years right before and right after retiring.

I think, rather than any age-based rule, it’s prudent to actually look at your own household’s specific circumstances: how harmful would a major stock market decline be, for you, right now? And the answer to that question (regardless of your age) pretty well informs the question of what asset allocation is likely to be appropriate. (And as always I’ll note that for any one household, there’s not one single allocation that’s “correct.” There’s a whole range of allocations that would be reasonable.)