By Dr. James M. Dahle, WCI Founder
“Hate” might be too strong a word, even if it did get you to click on this article. I don't hate total bond market index funds and ETFs (TBM). It can even be a reasonable component of a solid investment portfolio. It's just not my preferred bond option. Considering that a total stock market index fund is my favorite mutual fund and a total international stock market index fund comprises a good chunk of my portfolio, it's a little odd that I don't like the third member of the “three-fund portfolio” triumvirate.
However, I think I've got a few good reasons for this. Want to know what they are? Keep reading.
What Is a Total Bond Market Fund?
First, let's define what TBM is. We'll use Vanguard's version (BND) as our example, although there is a handful of other good (and nearly equivalent) TBM funds/ETFs out there. This discussion applies to all of them. As of May 1, 2022, TBM is a fund that holds a representative selection of the vast majority of bonds issued in the US by market capitalization and is comprised of:
- 47% Treasuries
- 27% Corporates
- 22% Mortgage-backed bonds
- 4% Other
There are over 10,000 bonds in the portfolio. It has an effective maturity of 8.9 years and an average duration of 6.6 years, and more than two-thirds of the fund is made up of US government bonds (67.5% is US government, 3.6% is AAA, 2.9% is AA, 12% is A, and 14% is BBB). It has a coupon of 2.9% and a current yield to maturity of 4.3%. It is available from Vanguard, Fidelity, Schwab, and iShares—and in both traditional mutual fund and ETF versions.
Problems with Total Bond Market Fund
Now that we've defined the fund, let's talk about why I don't use it.
#1 TBM Is Not Total
For something that purports to own “everything,” there are an awful lot of bonds that are not included in the fund. Here are some of the omissions:
- EE Savings Bonds
- I Savings Bonds
- Junk (High-Yield) Bonds
- Municipal Bonds
- Foreign Bonds
- Private Bonds
It's only a “one-stop shop” if you don't want any of that other stuff. Imagine if a total stock market fund left out REITs, tech stocks, and healthcare stocks. You wouldn't consider it to be very “total,” would you? You don't have to invest in everything, but if you're going to say you do, you actually should.
More information here:
What Bond Fund Should You Hold?
#2 No Inflation Protection
The main opponent of my portfolio is inflation. While inflation has been low for the vast majority of my investing career, I know that, in the long run, inflation is the most devastating lurking risk likely to disrupt my pathway toward my financial goals. I built the portfolio from the very beginning to withstand inflation as much as possible. Lots of stocks and real estate and even bonds are positioned to resist inflation reasonably well. Now that inflation risk has actually shown up, people are thinking a lot more about it. Inflation protection isn't new to me, though, and it is one reason I don't like TBM.
TBM is very exposed to inflation. While interest rates have increased in the past several months, you're still losing money to inflation with TBM.
So, how does this long term asset allocation in my bond portfolio help protect me from inflation? Two main things:
- Put half my bonds into inflation-indexed bonds like TIPS and I Bonds, neither of which is in TBM.
- Keep durations short to minimize loss due to rising rates and quickly allow the portfolio to start earning higher yields as rates rise.
TBM doesn't do either of these things. While you can find bond funds that do even more poorly in an inflationary environment, TBM is pretty bad.
#3 Takes Risk on the Bond Side
I prefer to take my risk on the equity side where it is more efficient (and not only from a tax perspective.) Corporate bonds (27% of TBM) carry inherent equity risk. When the company isn't doing well, the bonds become worth less due to the risk of the company going out of business. That risk doesn't show up in higher-quality bonds that are less likely to default. If you're going to run the risk of companies going out of business, I want to be paid more for it. You do that by owning the company, not by loaning it money. I don't take corporate risk with my bond portfolio. I only loan money to governments with the power to tax—either the federal government (G Fund, TIPS, I Bonds) or state and local governments (muni bonds). Then, I load up on stocks to get my equity risk.
If I really want to take risks with fixed income, I prefer to do it with private real estate debt funds and earn 7%-11%, not just the 4%-5% (and 2% a year ago) that TBM might give you. The purpose of the bonds in my portfolio is to be safe, so I keep my bonds safe. Relatively little interest rate risk (none with I bonds and the G Fund) and very little default risk.
More information here:
Here's Why I Don't Hold Bonds in My Portfolio
#4 Owns Mortgage Bonds
Mortgage bonds seem more attractive than Treasuries and corporates because they offer higher yields. However, there are some inherent risks of mortgage bonds. If rates go down, the mortgage holders refinance, and you have to replace your bonds with lower-yielding ones. They don't go up in value as much as other bonds when rates fall. When rates rise, nobody refinances (or even moves), but you're still stuck earning low yields. Only in a very stable interest rate environment do you come out ahead. It seems that we're never in any sort of a stable interest rate environment. So, why add that risk to your portfolio when it is so easy to leave it out?
#5 Bad in Taxable
For anyone in the higher tax brackets who has to hold a good chunk of their bonds in a taxable account (i.e. people like me), TBM is less than ideal. Less than half the fund is in Treasuries (which are state and local tax-free). Unlike muni bonds, all of the interest is fully taxable at your ordinary income tax rates. As I write this post, TBM and the Vanguard Tax-Exempt ETF (VTEB) have somewhat similar durations (6.6 and 5.5) and yields (4.3% to 3.2%.) If I adjust that 4.3% for my 37% tax bracket, it's really a yield of less than 3.0%. Why would I take less than 3.0% when I can get more than 4.0% with less term risk (shorter duration) and less default risk? I wouldn't.
More information here:
If You Want More Money, You Should Root for 2023 to Be Just Like 2022
Maybe you like TBM. That's fine. As I said, it's a good bond fund, and it can be a very reasonable part of a portfolio. There are many roads to Dublin. But it's not in my portfolio, and it probably never will be.
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What do you think? Do you invest in TBM? Why or why not? What other ways do you invest in bonds? Comment below!