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
- TIPS
- 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!
I’ve come to the same conclusion. I’m retired and my portfolio has 3 years spending in short term treasuries, 6 years in total bond market , the remainder in total stock and total international. I would like to eventually have all my bonds in short term treasuries. My “problem” is total bond market is down. I will wait for total bond market to hopefully recover.
This is a great post and aligns with many of my concerns about TBM funds. What suggestions do you have as an alternative that check all of the other boxes for white coat investors (low cost, easy to purchase in vanguard IRA/ROTH)? As the above comment suggests, for those who have been invested in TBM for years, would you recommend just holding now or changing strategies? It seems like the risk of “selling low” may not apply to bond funds like it does to stocks.
Totally get what you’re saying, and I’m also curious about other options out there. Now, from Jimbo’s point of view, he seems to be into stuff like government bonds, TIPS and I Bonds, and muni bonds, you know, ’cause they’re pretty safe and can sort of protect against inflation. He’s also hinting at keeping things short-term to avoid the drama of rising rates.
Now, about your question on whether to stick with or switch up your TBM strategy after all these years, remember that it all boils down to what you want financially, how much risk you can handle, and how long you’re planning to invest. Even though “selling low” might not work the same way with bond funds as it does with stocks, any changes to your game plan should be well thought out.
Like Jimbo always says, the best game plan is one you can stick with for the long haul. So, if you’re thinking about shaking things up, make sure it’s a strategy that jives with what you believe in and what you’re aiming for financially.
Well, you can avoid mortgage bonds with the Vanguard intermediate term bond fund. You can avoid corporates by using a treasury bond fund. You can largely avoid term risk by using short term bond funds. You can add a TIPS fund to get some inflation protection. You can add a foreign bond fund to get a more complete selection.
If your plan is TBM, then I’d hold TBM. I certainly wouldn’t sell because it went down in value. It’s a better investment now than it was 2 years ago.
Keep in mind most of these other types of bonds also lost money in 2022. So if you change from TBM to something else, you’re likely selling low and buying low.
I like this piece on Total Bond Market index funds and ETFs. You really opened my eyes about the whole inflation protection thing and the risks that come with mortgage bonds in a TBM. But, I’ve got a question. What’s your take on emerging market bonds? I know they weren’t in your article, but considering they might give higher returns and mix things up a bit, do you reckon they’re worth adding to an investment portfolio, or are they just too risky? Interested to get your thoughts on this
They probably provide some diversification but you don’t have to invest in everything. My general take on asset classes is that everyone should have at least 3, there are real benefits in going out to 7, and that beyond 10 the downside of complexity likely outweighs any additional diversification. I wouldn’t put emerging market bonds into my top ten list of asset classes to include.
This article would have been more useful a year or two ago. Now TBM is down 15-20% and you hate it? Well, thanks. It’s easy to hate now.
I listed five reasons I “hate” TBM. None of them was “it lost money in 2022.”
If you’re not a long term investor, don’t invest in long term assets like a bond fund. If you are a long term investor, ignore short term returns.
Great post Dr. Dahle as always. Clarifying questions though in regards to your point in #2.
1. Do you maintain this strategy regardless of if there is a higher than expected inflationary periods or if it is an expected ~2% period?
2. Please forgive my ignorance but isn’t this strategy almost like trying to time the bond market? If you are seeing higher rates then essentially changing your bond allocation dynamically rather than maintaining a fixed allocation. It would force you to make consistent predictions on the direction and amplitude of both inflation and compare them to the returns on yields.
1. I may not have worded it well. Mine is a long-term asset allocation. I don’t change it based on, well, anything.
2. Yes, it would be if I were doing that. I better rewrite that line so it doesn’t sound like I change my allocation when inflation goes up.
Long maturities are my biggest dislike. BND has about 12% of assets in maturities of 20 years and beyond. In 2020-21, the 30-year treasury was at 1-2%. Buying at those prices was a poor and risky investment.
“I only loan money to governments with the power to tax—either the federal government (G Fund, TIPS, I Bonds)…”. With the power to tax AND easy access to their printing press.
It’ll be interesting to see how the private RE debt does in the current environment. Especially if there is office exposure.
I don’t view real estate loans like private RE debt as bonds. I view it as real estate. The risk there is that a debt fund becomes an equity fund.
Good article, enjoyed it.
You mentioned if you want to take risk with fixed income you do it with private real estate debt funds for the higher yields. Could you not do this with a more liquid corporate bond fund? Something like HYG, LQD, VWEAX? You mentioned you prefer to take your risk with stocks, but do private real estate debt funds have less risk than corporate bond funds? Or less risk than something like PFF or PFFD the preferred equity ETF? Real estate debt funds generally have lock ups and do not have immediate liquidity as these ETF’s.
You also did not mention that longer duration bond funds such as BND have in the past have given 60/40 type portfolio holders a nice bump in price during recessions and stock crashes. In the 70’s recessions, 1990 recession, 2001, 2008….yields falling on gov’t bond yields helped cushion the crash of the 60% portion of the portfolio in stocks. And allowed rebalancing. Shorter term duration won’t give you that much of a price bump during recessions and stock crashes when yields plummet.
I would say the private real estate funds are far more risky than corporate bonds. I don’t even put them in the bond category honestly. I put them in the real estate category, although they may be one of the least risky ways to invest in real estate.
You’re right that when rates fall longer term bonds perform better. But as you learned last year, not all economic downturns are accompanied by falling rates.
Is there a Vanguard Muni Bond fund you can recommend? ONe that is stable and produces tax free income
Thanks
Vanguard Tax-Exempt Bond Index Fund
Fund ticker – VTEAX
EFT ticker – VTEB
California residents may consider:
Vanguard California Intermediate-Term Tax-Exempt Fund Investor Shares
Fund ticker – VCAIX
(also available in Admiral shares for $50,000 minimum investment for 8 less basis points)
If you want “stable” you want short term. All muni bonds produce federal and sometimes state tax free income. I like Vanguard bond funds so take a look at the Vanguard Limited Tax Exempt Bond Fund and the Vanguard Short Term Tax Exempt Bond Fund.
Thanks
Would be great if you could indicate the tickers
Thanks!
https://letmegooglethat.com/?q=Vanguard+Limited+Tax+Exempt+Bond+Fund
🙂
Thanks for the post. I have tried to aim for simplicity in my bond allocation which only accounts for 10% of my entire portfolio in my current accumulation phase. In my mind the main aim to keep bonds is to add diversity to my portfolio, kept in a tax protected account. I am sure there are many like me who don’t want to dwell too much into the weeds of bond funds with such a small allocation. For such a situation, is there a better option than the total bond market fund? That can be got at vangaurd ? Looks like VG short term treasuries might be a good option ?
Just about ANY Vanguard fund is reasonable if you’re only putting 10% into it. Certainly the following all are:
Short term treasury
Short term corporate
Short term bond index
Short term TIPS
Intermediate term treasury
Intermediate term corporate
Intermediate bond index
Inflation protected securities (intermediate TIPS)
Total Bond Market Index
VTEB is garbage at these rates. At 3.5% maybe.
VUSB pays ~5%, has shorter duration and is safer. Even if you use the 37% tax rate, you’re getting similar returns for way less risk. If Fed keeps raising rates VUSB will reset faster. (VGSH or BSV for more duration).
Plus any years you can reduce your tax rate it’s an even bigger win. (E.g. loss harvesting, multi-year donations in a Donar Advised Fund, etc.)
Michael Kitces refers to Bonds as “ballast” to stop your portfolio from jumping up and down as much and recommends shorter durations.
Munis aren’t defaulting right now, but don’t forget they CAN.
I trust VUSB way more and think VTEB needs a risk premium. Housing prices go down = less tax money. Not to mention pension obligations for aging workers.
You’re comparing apples to oranges. VTEB pays 3.25% tax free today. While VUSB is shorter duration and thus with our currently, inverted yield curve is relatively attractive yield wise the equivalent yield for a 37% bracket investor for VTEB is 5.2%. Just as the longer duration fund will do worse if rates go up, it will also do better if rates go down.
Yes, they are apples to oranges. I’m arguing that the oranges are better in your fruit salad and more appropriate.
VUSB or VGSH = Always Less Risk
The purpose of Bonds in a portfolio is to ride out the 12-18 months that the stock market tanks during a bear market.
Trying to get Alpha off bonds is forgetting the purpose of Bonds in the first place.
VTEB tanked hard in March 2020. It dropped from $54 all the way to $47.
The opposite of what you want in bonds.
To be clear, VTEB has a place, but I wouldn’t put all my eggs in that basket!!!
Don’t fear the tax man so much you make bad decisions. You can always hold your bonds in a tax advantaged account.
I’m just saying you could do short term muni bonds. They’re two separate decision. Short or intermediate. Muni or taxable.
Jim great post! Did the decimation of TIPS especially longer term ones last year despite 9.1% inflation make you reconsider your TIPS allocation and what types of TIPS you have? Do you no longer consider it as ballast to the equity portion of your portfolio and solely as a long term inflation hedge? Did you change your TIPS allocation to shorter durations?
Also, do you think the the new 3 fund portfolio that should be promoted is total US stock, total international, and total short term treasury fund? I agree TBM is a poor choice to act as ballast to the other 2 funds in this portfolio and that initially it was just easy to promote TBM. Do you think it’s possible now to change that paradigm among the Bogleheads? Do you even think we should? Or is adding that little bit of “short term treasury” complexity too difficult for novice learning investors?
No.
No.
I don’t think a 3 fund portfolio should be promoted at all. https://www.whitecoatinvestor.com/150-portfolios-better-than-yours/
No.
Not our job.
No, it’s not too complex. It’s a very reasonable choice.
Thanks for sharing another great post above. I also don’t like Vanguard’s Total Bond Market Fund because of the reasons you stated above.
For me, living in NY (a high income tax state), taxes matter and therefore, my fixed income holdings are only limited to municipal bond funds. My holdings are split between VMLUX (Limited-Term) and VNYUX (NY Long-Term) municipal bond funds. Right now, I even think simply holding cash in Vanguard’s Treasury Money Market (VUSXX) at 5% risk-free is more attractive than putting more money into other bond funds. Do you agree?
I don’t know that trying to guess future interest rate changes is a very good way to invest in bonds and that’s what it would take to answer your question. If rates go up, holding cash right now is the right answer. If they go down, long term bonds are the right answer.
I had the same response to Vanguard TBF (BND and BNDX). Look at returns for past 10-20 years. Pretty awful. Right now you can invest in T bills baying about 5.3%. Suggest short term (3-6 months) keep turning them over. You will do better than BND.
Your crystal ball seems so clear….It’s especially easy to make predictions without a time frame. Yes, cash will beat BND, but whether that’s over 1 month or over some more meaningful time period is not clear.
WCI,
Great post and very timely for me. I am starting a solo Cash Balance Plan where I intend to hold all of my bonds other than some I-Bonds I have at TreasuryDirect. I was going to use BND but your article brings up a lot of really great points. I’d like to have one bond fund in the CBP and already have my inflation hedge with the I-Bonds (so not interested in TIPS at the moment). If you were to recommend ONE bond fund in place of BND for a tax protected CBP (at Schwab), what would you recommend? Your comments are always appreciated.
I like the intermediate bond index fund at Vanguard as discussed above. Seems like it would meet your requirements. If you prefer to avoid corporates, you could do the intermediate treasury fund. Either is fine.
Awesome. Thanks for the insight and timely reply…as always!
I need advice on increasing my bond allocation. We have always maintained a good savings rate and have only mortgage debt but I never paid attention to asset allocation. We can hit 24% retirement savings rate within our 401k and a Roth IRA, so I have no taxable accounts yet. But I sat down to analyze our accounts and realize we are 93/7 on our stock/bond ratio.
Should I rebalance my account to achieve a higher bond allocation? Or use future dollars to purchase a higher percentage in bonds within the 401k?
We sat through 2021 and watched our accounts thinking, yuck, well good thing we aren’t retiring anytime soon. But otherwise unbothered by the drop.
Maybe 93/7 is right for you, hard for me to say. Have you written out a formal financial plan yet? I’d do that and then stick with it.
My very newly written plan calls for bonds at 15%. I think I’ll adjust new contributions to the 401k to get me to that goal over the next year. I’m researching the available bond funds now.
Thanks!
Hi Jim,
Thank you very much for the great work you’re doing on this blog. I’m currently doing my residency in Germany, and I wonder what your thoughts on mixed etfs are, i.e. ETFs that hold equity and bonds, like for example Vanguard LifeStrategy 60% Equity UCITS ETF Accumulating.
I mainly consider them interesting for tax reasons: Here in Germany, basically all capital gains are taxed flatly at about 25 to 27%, regardless of personal income tax brackets. The only exemption is ETFs with more than 50% stocks – those get a tax break of 30%, i.e. they are taxed flatly at about 18 to 20%. There are no tax-exempt accounts available.
Therefore, as far as I know, mixed ETFs are the only possibility to add Bonds to my portfolio at a reduced tax rate.
I wonder though, if there are any disadvantages inherent to mixed ETFs that outweigh those tax advantages. Do you have any thoughts on that subject?
As a general rule, I only recommended balance funds in tax protected accounts, but that’s due to US tax codes, Germany may be different. How does Germany tax the bond income in the funds? That’s what I’d look at before choosing to do this. Plus, I’d think long term. Will you be going to the US later?
Good point! It took me a while to research fund level taxation. Appreciation as well as earned interest apparently aren’t taxed on fund level. Hence, this definitely seems to be a significant tax break. Plus rebalancing inside the fund would not leed to taxable capital gains. Therefore I’m probably gonna include this ETF to my bond allocation. However, all the disadvantages you pointed out w.r.t. TBM are also inherent to Vanguard Lifestrategy. I’ll therefefore probably set up my bond allocation as follows: 50% inflation hedged treasuries, 25% short-term treasuries, 25% inside vanguard lifestrategy 60/40.
To answer your second question, I currently don’t plan to leave Germany. Anyway, I’m very glad to have found your blog. You inspired me to finally set up a written IPS. Keep up the good work!