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What’s the Best Bond Fund or ETF?

If you could select one of the following funds to serve as a diversifier for a stock-oriented portfolio, which would you choose?

I’m currently using Total Bond Market for the bond portion of my portfolio, but I’m considering switching.

The Differences

The difference in expenses between the funds is quite small, so that leaves two factors for deciding: credit rating and maturity.

The Total Bond Market fund is roughly 34% Treasury securities, 38% government-backed mortgage securities, and 28% corporate bonds. The other two funds are obviously 100% Treasury securities.

The Short-Term Treasury Fund has an average maturity of roughly 2 years, while the Intermediate-Term Treasury Fund and Total Bond Market fund have average maturities of roughly 6 years.

Treasury or Total Bond Market?

The primary reason I’m considering switching out of the Total Bond Market Index Fund is that it holds 28% of its portfolio in corporate bonds.

When investors get scared about the prospects of our economy (as they did in late 2008), they tend to sell corporate bonds as well as corporate stock. So it would seem reasonable to expect stock market performance to be more closely correlated to corporate bond performance than to Treasury bond performance. (The return data posted on Vanguard’s site seems to confirm that suspicion, though it only goes back to 1994.)

Their lower correlation to the stock market would mean that either of the Treasury funds would work as a better diversifier than the Total Bond Market fund.

The downside: Due to their lower-risk profiles, the Treasury funds should have lower expected returns than the Total Bond Market fund.

Short-Term or Intermediate?

The shorter a bond’s maturity, the less sensitive it is to inflation risk and interest rate risk. As a result, the short-term fund exhibits less volatility (in terms of annual returns) than the intermediate-term fund. In exchange, it should earn slightly lower returns over extended periods.

The flip side, however, is that precisely because of its greater exposure to interest rate risk, the intermediate-term fund has historically exhibited lower correlation to the U.S. stock market. (That is, during market crashes, if investors panic and flock to Treasury securities, interest rates will go down and bond prices will go up. The longer the maturity of a bond, the greater its price will increase.)

For me, if an asset class has higher long-term returns and lower correlation to the rest of my portfolio, that’s a good thing. And even if its stand-alone volatility is higher, it may lead to a less volatile overall portfolio.

What do you think?

As you can probably tell, I’m leaning toward switching to the Intermediate-Term Treasury Fund, but I’d love to hear your thoughts on the matter.

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  1. I would stick with Total Bond Maket Index fund.

    This fund is highly regarded by many experts. (John Bogle, Burton Malkiel, etc.)

    You get greater diversification within classes/types/maturities of bonds, and constant rebalancing. There might be a time when people run away from Treasuries and go to GNMAs and/or corporates.

    Total Bond Market is “stable enough” in turmoil events.

    It sounds like your bored with your portfolio or you need to change something to write about.

  2. Mike,

    I’m kind of surprised you’re doing the asking here as you’re usually the one dispensing the advice. But when I read this —

    “When investors get scared about the prospects of our economy (as they did in late 2008), they tend to sell corporate bonds as well as corporate stock. So it would seem reasonable to expect stock market performance to be more closely correlated to corporate bond performance than to Treasury bond performance.”

    — it makes me wonder if in effect you’re disregarding your own advice and trying to time the market. (I.e., the flip side being, “when investors are confident, they tend to buy corporate bonds as well as corporate stock.”) Isn’t the best advice really to decide on an allocation strategy and then stick to it “obliviously,” perhaps adjusting it only on an age-related basis?

    That said, FWIW, I was advised by my personal source when going into Vanguard to put about 50% of my bonds into the Total, with the rest divided between the GNMA and TIPS funds.

  3. Larry,

    I don’t think Mike is straying from his own advice here. His comment about what investors do when they panic is not about timing. The point he’s making is that if you want the bond portion of your portfolio to be safe and stable when stocks are going down (people are panicking), then it’s historically better to stay away from corporate bonds.

    I’d say he’s exactly right in this respect. And as he pointed out, if you decide to go only to Treasury bonds you should expect a lower return. This is a legitimate question for any investor, but especially for “oblivious” investors.

    Mike, I’d say a mix of short and intermediate term Treasuries would be good for those in retirement. But for those who have many years until retirement, like us, you’d be fine with just the intermediate term bonds. Thanks for bringing up a good point!

  4. Mike,

    Great post and thanks for bringing to your readers’ attention that not all bond funds are created equally.

    I think being aware of the corporate bond exposure is the most important part. If corporate bonds fit as part of your overall allocation, then great.

    Personally speaking, I try to keep my risk on the equity side, so I tend to stay short-term and high quality on the fixed income side using similar investments to those that you mentioned.

    I think it really just a matter of personal preference provided you’re aware of how corporate bonds are correlated with the rest of your portfolio.

  5. I don’t pretend to be an expert on any of this, but it seemed to me that Mike’s question was based on a reaction to a present trend in the market, rather than on a fixed strategy that can be kept in place permanently – leading to the question in my mind, if investors start buying corporate stocks/bonds again in the future, would he reallocate to have a larger percentage in corporate bonds? That’s why it sounded like market timing to these admittedly inexperienced and often confused ears.

    Paul Williams’s analysis raises a larger question in my mind – being far or near to retirement age. Maybe this isn’t the right thread for this, but here goes: the way I read most PF writers, if you don’t have a certain set amount in your portfolio by retirement age (65, 66, or whatever), you’re more or less a dead duck. I don’t deny that at age 61 I’m rather concerned myself. I learned about Vanguard and index funds only about 7-8 years ago, and before that made a number of mistakes that doubtless cost me in the long run (such as not being aggressive with equities when I was 30 or so, and then later investing my IRA with Merrill Lynch and getting suckered into high-expense loaded growth funds that lost big time around 2001, as well as not having started a Roth until I switched to Vanguard). Even so, I’m not doing terribly and probably better than most.

    But the way it seems to me is: being a bit more aggressive may well be a better strategy at any age, because even if you’re 65 and withdrawing your 4-5%, you could have 20-30 years ahead of you and your money can continue to compound without your making further contributions. If you start slowing down at 65 and put a lot into bonds, you face greater inflation risk – which is why I think a cash-based “expert” like Suze Orman seems to think you can’t retire unless you have a million or more at 65. But even if your stocks decline 50% for a year or two, they will eventually recover and it’s not as if you’re withdrawing your entire portfolio as a lump sum. Hope I’ve expressed myself clearly enough here; I was writing this fast.

  6. Larry,

    The problem with being aggressive while you’re withdrawing is that volatility has a much harder impact on your portfolio. If you withdraw $20,000 after your portfolio has gone down 30%, it’s hard to recover from that loss. But if you’re not withdrawing yet, there’s more money in your portfolio when the market starts to recover – meaning it’s easier for your personal portfolio to recover from the loss.

    If you’re nearing retirement and worried that you don’t have enough saved, you should be focused on increasing your returns – but even more so on reducing your costs. The more ways you can save, the much higher your chances of retirement success.

  7. With interest rates as low as they have been in decades and all this artificial stimulus and easy money in the system, there is only one direction they will take as the economy recovers— up. And it will recover eventually no matter what quick fixes the politicians inflict on the economy. I want short-term durations when the direction of interest rates is this clear, and I’ll trade lower interest for capital preservation. The time to go intermediate term is coming in the next couple of years.

    Treasuries are the closest thing to a bubble in the bond market right now and will be hurt the most by rising interest rates, especially long and intermediate.

    I’d be looking at Vanguard Short-Term Bond Index, and wouldn’t run away from corporate bonds.

  8. Ziggy: I wouldn’t say I’m bored with my portfolio per se. This is a change I’ve been pondering for almost a year now, so I’m not exactly rushing into it.

    And I’m certainly not saying the Total Bond Market fund is a bad fund. I just suspect that it might not be as effective at diversifying a primarily stock portfolio as a Treasury fund would be.

    Also, I regard Bogle and Malkiel very highly, but their recommendation isn’t sufficient for me to include it in my portfolio–especially when other experts I greatly respect (David Swenson for example) recommend in favor of a treasury fund.

    And as to “stable enough,” that’s not exactly what I’m going for. (Or at least, that’s not all I’m going for. If it was, I’d go with cash! :)) If a Treasury fund reliably has a lower correlation to the rest of my portfolio (and the data I’ve found so far indicates that, historically, it has) that seems to make it a better diversifier.

    In fact, if it has a negative correlation to the rest of my portfolio, higher volatility may in fact be a good thing, as it will lead to less overall portfolio volatility, as well as the opportunity for a larger rebalancing bonus.

  9. The Biz of Life: You may well be right about where interest rates are headed next. Honestly, I don’t really know. To me though, the question is more of “what fund do I want to buy & hold for the next few decades?”

  10. Paul: Thank you for your input.

    Larry: I think we’re more closely on the same page than you might think. To your question, “Isn’t the best advice really to decide on an allocation strategy and then stick to it “obliviously,” perhaps adjusting it only on an age-related basis?” …I’d answer “yes.”

    The question I’m trying to answer here is simply “which fund should I be using for the (currently small, due to my age and risk tolerance) bond portion of my portfolio?” Once I pick the fund, I intend to stick with it!

    As to the question of how aggressive one’s retirement portfolio should be, Paul raises an important point: The order of returns matters a great deal when you’re in the selling stage.

    If you have a high-risk portfolio as you move into retirement, whether you encounter a bull market or a bear market in the first few years of retirement can make a tremendous difference in how the entire rest of your life plays out. Bull market first, and you get to live the high life for the remainder of your years. Bear market first, and you have to cut costs to the bare minimum for the next 3 decades.

    In other words: For retired investors especially, “high-risk” portfolios are in fact high-risk portfolios.

  11. Mike,

    have you considered commodities, gold and other alternatives beside bonds? If no why not?

  12. Mike, then stick with the fund you are already in if you intend to hold it for decades and can handle the temporary losses associated with rising interest rates. That way you capture the return of the entire bond market for the period of time you hold the fund and spread your risk across corporates, GSEs and Treasuries.

  13. “If you have a high-risk portfolio as you move into retirement, whether you encounter a bull market or a bear market in the first few years of retirement can make a tremendous difference in how the entire rest of your life plays out. Bull market first, and you get to live the high life for the remainder of your years. Bear market first, and you have to cut costs to the bare minimum for the next 3 decades.”

    That’s encouraging news! So I think you mean – don’t keep 100% in gold until the day you die, or something like that. Or even 100% in stocks.

    So would a 50/50 split be about right for someone 65 who doesn’t yet have a portfolio worth 1 million?

  14. I’m in the intermediate-term government bond camp, mostly for the reasons you discuss. “Intermediate-term” is loosely defined, so you ought to weigh at a couple of other options in addition to the Vanguard one you mention. iShares has an ETF that tracks the Barclay’s 7-10 year treasury index, and Fidelity has a Spartan fund that tracks a slightly mellower Barclay’s 5-10 year treasury index.

    The Vanguard ETF you mention is pretty new and should track the even mellower Barclay’s 3-10 year treasury index, but I don’t think the Vanguard mutual fund you mention is actually an index fund.

  15. J: My thoughts on gold pretty closely mirror those of William Bernstein. That is, it can play a diversifying role due to its lack of correlation to the stock market and its high volatility. That said, precisely because of that volatility, it makes sense to keep it to a small portion of one’s portfolio.

    Larry: A 50/50 stock/bond allocation could be appropriate for a 65 year old investor. It depends, of course, upon how comfortable that person is psychologically with volatility. It depends upon how high of a starting withdrawal rate that person is going to need to use to pay the bills. It depends upon the presence other financial assets not included in the allocation (a pension, or a completely-paid-off home for instance). You get the idea.

    Sorry to be so dodgy with the answer here. I know it comes across as terribly unhelpful, but I think that just saying “yep. 50/50 sounds great!” is probably even less helpful.

  16. Mike: Certainly I understand where you’re coming from. There are numerous factors to factor in. Where I get uncomfortable is in making psychological comfort with volatility a major component. Fund A is going to rise and fund B going to fall no matter what my degree of psychological comfort. A friend of mine, a CEO at a small reinsurance company, accepted a buyout some years ago and insisted on taking it all in cash because he felt more comfortable. I wonder how much inflation has robbed him while he’s feeling all that comfort.

    I just bought the Bogleheads’ book on retirement planning and hope to gain more insights there, but I’d like to think I’ve gone past the point of being swayed by my emotions and am looking to know now what would be the best strategy for me based on how money actually works. Much as I dislike Dave Ramsey, I would agree with his impatience towards those who wanted to bail out of stocks when the market crashed over a year ago. Me, I just yawned, rebalanced my IRA back to my targets (which meant buying a lot of stocks), and now they’re up 20 or 30% from their low.

  17. Mike,

    According to Fama and French’s research “Common Risk Factors in the Returns of Stocks and Bonds”. It appears that term risk and credit risk are not sufficiently compensated.

    If the conclusion is taken at face value, I would go with the short-term treasury bond fund.

    By the way, being the company most influenced by Fama and French’s thoughts, DFA’s modus operandi is to avoid corporate bonds and long-term Treasuries.

    Michael Zhuang

  18. Hi Michael.

    Thanks for sharing that paper. I’m about 14 pages into it so far.

    I’m in complete agreement that, when compared to short-term Treasuries:
    a) intermediate-term Treasuries carry higher risk (as measured by standard deviation of annual or monthly returns) and
    b) their returns are not much higher.

    My question is this:
    If intermediate-term Treasuries reliably have lower correlation to stock market performance, isn’t it possible that they’d lead to lower overall portfolio volatility than short-term Treasuries, even though they have higher stand-alone volatility? And if so, wouldn’t they make a better diversifier even if they offered no additional expected return beyond that earned from short-term Treasuries?

  19. I think the reason to use short term bonds in a portfolio is that short term bonds *don’t go down* when stocks go down, not because they go *up* when stocks go down, and because their yield is typically better than cash. Cash is the best diversifier, its correlation is zero.

    Now it seems that with intermediate term bonds you are looking for an asset with negative correlation with the stock market, not “lower correlation” — unless by “lower” you mean go past zero to negative.

    The question then is how much are you willing to pay for negative correlation and why. If you short the market, you get perfect negative correlation – but your “hedging” asset goes down so much that it doesn’t help you – it cancels out your gains in the stock market. This is zero volatility – no loss no gain! 🙂

    You can construct a security with a desired negative correlation – say a negative correlation of 0.2 by constructing the security with 80% cash and a 20% short position. But again, that doesn’t help you, it just cancels out a portion of the stock gains. Similarly, if intermediate term bonds go *down* when stocks go *up* they will be canceling out your gains on the upside.

    What you really want is as close to zero correlation as possible, at as little cost (i.e. loss of yield) as possible and short term treasuries fit the bill. Cash would be a better diversifier than short term bonds, if it had a higher yield.


  20. I was going to say you’d clearly taken Swensen to heart, Mike, then I read in your comments as much… 😉

    It’s interesting to note that Swensen actually liked corporate bonds at the start of 2009.

    I think that window of extreme disruption making corporate bonds more attractive has probably largely closed now. The only thing that makes really returns look juicier than normal is the yield gap with government bonds, and I expect that to be closed by government bonds rising, although clearly that’s not a very oblivious comment and is just my humble guess… 😉

  21. Monevator: Indeed, Swenson’s book has given me lots to think about. Bernstein’s Investor’s Manifesto also has a section about the very attractive yields on corporate bonds. Unsurprisingly, by the time the book was actually published, those yields had dropped considerably.

    Joppy: Thank you for your thoughtful comment.

    You’re absolutely right it’s easy to get an asset that’s negatively correlated to the stock market–as long as you’re willing to accept negative expected returns.

    You say, “it seems that with intermediate term bonds you are looking for an asset with negative correlation with the stock market, not “lower correlation” — unless by “lower” you mean go past zero to negative.”

    I think I disagree. When comparing short-term Treasuries to intermediate-term Treasuries, I really am just looking for lower correlation. Whether that correlation is a lower positive number or a greater negative number, it still ends up doing a better job of diversifying. And the cost in expected return is negative if anything, given that intermediate-term bonds have a greater expected return than short-term bonds.

  22. Your analysis of correlation to equities is something I have looked at for some time as well. However, you can even go one step further and show that long term treasuries will provide even lower volatility in an overall portfolio.

    I wouldn’t go to long term at this point with interest rates only able to go in one direction, but I’ve been considering the addition of a long term bond index as part of a bond allocation (perhaps 25% of the bond allocation) to provide reduced volatility and higher returns.

    Incidentally, Jack Bogle speaking at a Bogleheads convention recommended not using Total Bond Index because he does not like the inclusion of mortgage backed securities. He instead recommended using the Intermediate Bond Index as the core of a bond allocation.

  23. Hi Jeff.

    Thanks for contributing your thoughts. 🙂

    I agree that with rates as low as they are, it’s not a particularly attractive time to purchase long-term bonds. For anyone already in Total Bond Market Index though (myself, for example), shifting from Total Bond to the Intermediate-Term Treasury fund wouldn’t increase the duration of the portfolio.

    And that’s fascinating about Bogle recommending a fund other than Total Bond Market. I’ve always thought of him as the champion of the Total Stock Market Index and Total Bond Market Index portfolio.

  24. I went back to my notes from Bogleheads VI in DC in 2007 and these are the notes from Jack’s discussion related to bond allocation:

    -Doesn’t personally like Total Bond Index because it includes Mortgage securities (GNMA, etc) which are not really bonds. Prefers Intermediate Bond Index but he concluded that it really is an economically benign decision.

    -Recommended within the bond allocation (1/3 Municipal (in taxable), 1/3 Interm Term, 1/3 Limited or Short Term).

    -Mentioned that if you aren’t going to look at your funds for 20 years or more, go with long term bonds to get the better yield.

    -Prefers Short Term Bond fund over money market fund.


  25. “It really is an economically benign decision.”

    I often wonder how many of the things I write about here are in (or near) that category…

    Thank you for sharing those notes; I always enjoy hearing Bogle’s thoughts. I’m envious that you’ve gotten to attend a Bogleheads convention!

  26. This (the total bond index vs. intermediate debate) is not a huge concern for me at this time. My portfolio is 10% in bonds. 28% (the amount of total bond index that holds corporate bonds) of 10% is 2.8% of my overall portfolio. If I want to hunt for diversification or more uncorrelation, I will look at the other 97.2% of my portfolio to do that.

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