Why You Should Avoid Most Bond Index Funds

There’s a lot to like about index funds. Over the long term, stock index funds have beaten about two-thirds of actively managed funds -- largely because index funds generally charge much less. But bond index funds are a different story. Indeed, Vanguard Total Bond Market (symbol VBMFX), with assets of $118 billion, has lagged slightly more than half of actively managed funds in its category over the past 15 years despite charging much less than the average taxable bond fund. Over the past five years, the fund trails 81% of active funds.

Why? The biggest factor is the enormous amount of government debt. Most stock indexes weight securities by their market value (share price times number of shares outstanding). An example: Apple (AAPL) has some 6 billion shares outstanding and recently traded at $95.97. Multiply the two numbers and you get its market value of $579 billion. (All prices and returns in this article are through July 7.) Apple has the highest market capitalization of any U.S. company, so it accounts for 3.3% of Standard & Poor’s 500-stock index.

A company’s stock market value is influenced slightly by how many shares it issues. But the much bigger factor is how popular the stock is with investors. Since going public in 1980, Apple has climbed nearly 200-fold.

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Bonds are different. Yes, they rise and fall in price, but not nearly as much as stocks do. The price of an investment-grade bond typically doesn’t deviate much from the price on the day it was issued. That means the most important factor in its market value, and thus its weighting in an index fund, is the size of a particular issue.

And herein lies the rub: The federal government is $17 trillion–plus in debt. No U.S. company -- or companies in aggregate, for that matter -- has issued anywhere near $17 trillion worth of bonds.

The Vanguard fund, which tracks Barclay’s U.S. Aggregate Float Adjusted index, has 65% of its assets in U.S. government debt. The biggest share of that is in Treasury securities, but the fund also has 21% in government- backed mortgage securities. (The float-adjusted index excludes bonds held by the Federal Reserve, which has been trying to depress bond yields and other interest rates through its massive government-bond purchases.)

So when you buy the Vanguard index fund or a similar fund sponsored by another firm, you’re investing 70% of your money in government debt. That’s a giant allocation -- way too much, in my view.

Even Vanguard founder Jack Bogle, who practically invented index funds, says 70% in U.S. government bonds is too much. He’s proposed that the index be reworked to increase its exposure to corporate bonds.

One caveat: Because bond index funds own so much U.S. government debt, where there is little risk of default, these funds should hold up well in financial meltdowns. For instance, in 2008, the Vanguard index fund returned 5.1%, beating its peers -- funds that invest mainly in taxable investment-grade, intermediate-term bonds -- by an average of 9.8 percentage points.

The same government-debt bugaboo holds for foreign and global bond index funds, says Sarah Bush, a Morningstar analyst. Vanguard Total International Bond Index (VTIBX) has 81% of its assets in foreign-government bonds, topped by a 22% weighting in Japanese government securities, whose 10-year bond yields about 0.6%. Her advice on bond funds: “I lean toward actively managed and low-cost funds.”

What to do? Following are three options -- from my favorite to least favorite.

The first strategy is outlined in The Four Best Bond Funds to Own Now, which recommends minimizing the risk of rising bond yields (and their accompanying falling prices).

Second strategy: Among more-conventional bond funds, Fidelity Total Bond (FTBFX) is a solid choice. Over the past five years, the fund, a member of the Kiplinger 25, returned an annualized 6.7% -- 2.0 percentage points per year more than Barclay’s U.S. Aggregate Bond index. The fund’s average credit quality is triple-B. If interest rates rise by one percentage point, figure on the fund losing about 5% of its value. (Bond prices move in the opposite direction of rates.) Expenses are 0.45% annually.

Third strategy: If you’re a dyed-in-the-wool indexer, focus on funds that own high-quality corporate bonds. Vanguard Intermediate-Term Investment Grade (VFICX) has only about 6% of its assets in government bonds. Almost all the rest is invested in corporate bonds. Because the bonds are all high-quality, the fund steers away from overly indebted companies. Over the past ten years, the fund, which charges just 0.20%, returned an annualized 5.8% -- putting it ahead of only half of its peers. Be aware, too, that the fund has about 70% of its assets in bonds issued by industrial and financials companies, which tend to rise and fall with the economic cycle.

Steve Goldberg is an investment adviser in the Washington, D.C., area.