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The Conservative Vanguard Total Bond Market ETF

This ETF takes less credit risk than most of its peers, so it offers a lower yield, but its cost advantage gives it a durable edge. 

Alex Bryan, 11/11/2016

Vanguard Total Bond Market ETF BND is a solid, low-cost option for core exposure to investment-grade bonds. It efficiently tracks the Barclays U.S. Aggregate Float-Adjusted Bond Index, which tilts toward high-quality investments. The fund's heavy exposure to U.S. Treasuries and agency mortgage-backed securities somewhat limits its return potential. However, its sizable cost advantage should translate into attractive risk-adjusted performance relative to the intermediate-term bond Morningstar Category over a full market cycle, supporting the Morningstar Analyst Rating of Silver.

The fund offers broad exposure to liquid, U.S.-dollar-denominated investment-grade bonds with a least one year until maturity. This creates a well-diversified portfolio consisting of thousands of securities. It weights them by float-adjusted market capitalization, tilting the portfolio toward low-yielding and relatively secure government bonds and agency MBS. These high-quality bonds form just over 60% of the portfolio.

The portfolio's bias toward high-quality investments should help it to weather tough economic climates better than most of its peers. During 2008's financial crisis, for example, the fund gained 5.2% while the average fund in the category lost 4.7%. Many of its peers continue to hold more corporate bonds and include out-of-benchmark bonds in an effort to earn higher returns. Though corporate bonds have largely outperformed in the years following 2008's crisis, they do add credit risk relative to the government-backed bonds that dominate this fund's portfolio.

The fund's conservative credit-risk profile reduces its return potential, but low fees help make up for this, giving the fund a durable edge against its peers. It charges a rock-bottom 0.06% expense ratio, while the average fund in the category charges 0.80%. This cost advantage helped the fund slightly edge out the intermediate-term bond category average by 47 basis points annually over the trailing 10 years through September 2016.

Fundamental View
The case for investing in a broad market-cap-weighted investment-grade bond index is similar to the case for stock indexing. Such a portfolio reflects the composition of the bond market, harnessing active investors' collective wisdom at a lower fee. It is a low-turnover strategy that favors the most-liquid bonds in the market, making it cheap to implement. But there are some drawbacks.

Market-cap weighting skews the portfolio toward the most heavily indebted issuers, which in the investment-grade bond segment leads to a large weighting in low-yielding government Treasuries. This large weighting is not representative of how many active mutual fund managers in the intermediate-term bond category invest. That's because the bond market includes large investors who have different objectives, such as banks, which often use Treasuries as a safe place to park excess cash, and insurance companies, which use Treasuries to match the duration of their liabilities.

Because of its large exposure to Treasuries and conservative credit-risk profile, the Barclays U.S. Aggregate Bond Index, which the fund tracks, isn't a difficult benchmark to outpace, gross of fees. Active managers can, and often do, boost their yields by simply taking more credit risk, which doesn't require any skill. Over the long term, credit risk has tended to pay off, but this isn't a free lunch. Lower-quality bonds tend to underperform in tough market environments when credit spreads widen and generally exhibit greater volatility. Over a full market cycle, the fund should generate similar risk-adjusted performance to its category peers, gross of fees. Net of fees, it should come out ahead.

This is a high-quality portfolio with a hefty allocation to U.S. Treasuries, which accounted for 39% of the portfolio at the end of September 2016. In total, U.S. government-related debt, including agency MBS, accounted for over 60% of the portfolio. This is considerably greater than the category average. That exposure largely explains the fund's 69% stake in bonds rated AAA at the end of September, while the corresponding figure for its typical category peer was 52%. Its peers also tend to have greater exposure to securitized debt.

While it takes less credit risk than it typical peer, the fund has slightly greater exposure to interest-rate risk, which could hurt performance during periods of rising rates. It also exposes investors to moderate inflation risk. Bond yields currently reflect low inflation expectations. In fact, the five-year break-even inflation rate was 1.45% at the end of September 2016, according to the St. Louis Fed.

At the end of September, the fund's yield to maturity (2.2%) was lower than the category average (2.7%), owing to its higher-credit-quality portfolio. But its cost advantage should more than make up the difference over the long term.

Portfolio Construction
The fund employs representative sampling to track the Barclays U.S. Aggregate Float Adjusted Index, a broad proxy for the investment-grade U.S. bond market. This broad portfolio effectively diversifies risk, tilts toward the most liquid securities, and promotes low turnover, supporting a Positive Process Pillar rating.

The fund's index includes investment-grade corporate, government, and agency and agency-backed debt denominated in U.S. dollars with at least one year until maturity. However, it excludes agency and mortgage-backed securities held by the Federal Reserve. The index weights its holdings by float-adjusted market cap and is rebalanced monthly. The fund does not hold every security in the benchmark, but instead carefully replicates the index's key characteristics, such as duration and credit quality. The managers also attempt to closely match the benchmark's sector and industry weightings. Effective management has kept tracking error fairly low over the trailing three years through September 2016.

Fees
Vanguard charges a low 0.06% expense ratio for this offering, making it one of the cheapest funds in the category. Therefore, it earns a Positive Price Pillar rating. On average, funds in the intermediate-term bond category charge 0.80%. Over the trailing three years through September 2016, the fund's performance has lagged its benchmark by 5 basis points annually.

Alternatives
There is a separate mutual fund share class of this fund, Vanguard Total Bond Market Index VBTLX, which carries the same expense ratio and has a $10,000 minimum investment requirement.

IShares Core US Aggregate Bond AGG (0.05% expense ratio) and Schwab US Aggregate Bond SCHZ (0.04% expense ratio) are the next closest alternatives. They both track the Barclays U.S. Aggregate Bond Index, which is identical to BND's index, except it does not adjust for bonds held by the Federal Reserve. However, this difference has not had a big impact on their portfolios or performance.

IShares Core Total USD Bond Market ETF IUSB (0.08% expense ratio) offers broader market-cap-weighted exposure to the U.S. bond market than the Barclays Aggregate Bond Index. It includes both investment-grade and high-yield bonds, which gives it a slightly higher yield to maturity.

PIMCO Total Return Active ETF BOND (0.57% expense ratio) is a compelling actively managed alternative. It applies a very similar strategy to Bronze-rated PIMCO Total Return PTTAX (0.85% expense ratio), though it has a much smaller portfolio. Both funds aim to beat the Barclays U.S. Aggregate Bond Index through macroeconomic bets and security selection. 

  

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Alex Bryan is an ETF analyst with Morningstar.

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