Fri, 19 Apr 2013
The benchmark index doesn't reflect the true allocations of U.S. bond investors, and the industry needs to look again at corporate-bond index funds or rework the current index, says Vanguard founder Jack Bogle.
Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Investors have been heavily buying equity index funds, but they have been less enthusiastic about indexed bond products. Joining me to discuss role of bond index funds in investor portfolios is John C. Bogle. He is the founder and former chairman of the Vanguard Group.
Jack, thank you so much for being here.
John C. Bogle: It's always fun to be with you, Christine.
Benz: Let's talk about bond indexing, Jack. We've seen performance of [broad market] bond index funds relative to our intermediate-term bond category look a little [volatile] in recent years. So, in 2011 they did great. More recently they haven't looked as good. Active funds have actually done better. What do you think is the underpinning of that performance bifurcation?
Bogle: There is just no doubt about what the underpinning is, and that is the Barclays Capital U.S. Aggregate Bond Index is very heavily weighted around 70% in U.S. Treasuries and U.S. agencies, government instruments, if you will. And that 70% is working at a very low yield, and the other 30% probably much more resembles what the average bond fund is doing out there, the intermediate-term bond fund, which is the appropriate maturity.
Benz: So, the intermediate-term funds, the active funds, are generally heavily skewed toward corporate bonds?
Bogle: Very, very much so.
Benz: One thing when you look at current yields of say corporate bonds versus the Barclays Aggregate Bond Index, you see that corporate bonds have a big leg up in terms of current yields, 1.2% roughly for the Barclays Aggregate and roughly close to 3.0% for corporate bonds. And given that historically current yields have been a good predictor of future bond market performance, why would anyone hunker down in the Barclays Aggregate given that yield disadvantage?
Bogle: Well, let me first say that the Barclays bond indexes are cost-free. And if you look at the average return of a managed intermediate-term bond fund, their average yield is 1.65%. That's a long way from that almost 3.0% that you just mentioned. And that's because they have an average expense ratio of 90 basis points.
Again, that sales charge is one more cost. That's not taken into account here, and that's another point. So, for a five-year holder of an intermediate-term bond fund, by the time when that corporate index is yielding, say 3%, he loses almost a point, 100 basis points, to expenses and other 100 basis points to sales charges.
So, in the long run, the appropriate index is going to win, and the problem we're dealing with right now is that the Barclays Agg is so heavily loaded with government [bonds] that it's not a fair comparison.
Benz: How should investors than think about constructing their bond portfolios? Should they maybe own a total bond market index fund as an anchor and then augment it with extra corporates, or how should you think about putting together a portfolio that will give you that ballast you need, but also give you a reasonable rate of return?
Bogle: Well, Christine, this answer may surprise you from a dyed-in-the-wool indexer and the creator of the first index bond fund. I think we have to fix the index. And the fact of the matter is in that $16 trillion or so just of Treasuries alone here, what we are dealing with is huge amounts that are held not by U.S. investors, but foreign investors. And if you look at the data, you see that about $5.5 trillion of that $16 trillion is held by China and Japan and a couple of other countries, that's irrelevant to the U.S. investor in my opinion.
So, when you look to what's relevant--how much is in Treasuries--well, it's not $16 trillion, it's more like if you had pension funds and bond funds and individual investors, we are talking $2.7 trillion. That's what should be in the index in terms of the government position in my opinion. When we look at how U.S. investors do, the government position in the index should be about half of what it is maybe a third of what is. So, we've got to fix the index.
Failing that, there are a couple of options. One, this industry really needs a corporate-bond index fund. It doesn't seem to think it does, but that gets to the root of your question and again leaving expenses out. If a corporate-bond index fund could produce the same yield as the [Barclays Aggregate Bond Index], and I'm using a number of 2.8% before costs, you know, that should be the return over the next 10 years for the corporate-bond index.
The yield on the total bond market index is now 1.4%-1.5%, and those numbers, as everybody now knows, are an excellent proxy for the total return you earn on your bonds over the next decade. So, if you earn 1.5%, your total return will be about 20%. And if you earn, let's say 2.8%, you will earn probably 35%, almost doubling compound return.
So, yes, investors should be thinking, "Are we willing in this day when we are starved for income, are we willing to take a little more duration risk? Because the revised index would be a little longer, Treasuries are probably shorter-term, and are we willing to take a little more credit risk?" Corporate bonds are probably in the A area, maybe A, BBB, and the federal government bonds, depending on which rating agency you are looking at, is either AAA or AA, and you have to make your appraisal if that's a reasonable risk spread for that gap in yields.
On the other hand, I wouldn't go all the way to corporates. I'd keep these Treasury positions. So, if we don't have an index fund that accurately reflects the total bond market for U.S. investors, you maybe take half of that and put it in a corporate-bond index fund.
Benz: So, the idea is that the total bond market index funds will tend to hold up better in that sort of true flight to quality, where the equity market tanks and corporates do, as well. So you want to hang on to least some of that Treasury exposure?
Bogle: Well, yes, except, I'm not sure that that flight to quality, which even came up a couple of days ago when the markets fell apart, I'm not sure that flight to quality is durable. And you can't trade it, getting in and out before and after the flight to quality. So, I think it's a net drag almost inevitably, and you see this really more than anything else--you mentioned this I think in the introduction--that you have years like 2008, where the total bond index goes up 5.1%, and the intermediate-term corporate-bond index goes down 4.7%. That's a 10% gap. And, yet, it more than made up with in favor of the intermediate-term bond fund average the next year and a little in 2009. It's double--6% versus almost 14%. And the next year its 6.5% for the bond index and 7.7% for your intermediate-term bond fund. And the next year it turns around again. It's amazing how much difference there is in this, 7.7% versus 5.9%. And then this year is another bit of a turkey, this is the year 2012, I use the term turkey loosely, 4.1% total return for the bond index and 7.0% for the intermediate-term corporate-bond average.
Investors have to be aware of those differences. They have to be aware of the credit difference. They have to be aware of the duration-lengthening that's not long, maybe 1.5 years or something like that, and decide they either want to get that income or not. It comes down to the purpose of the bond fund, which is normally, A, protecting the portfolio in declining markets, and B, to give you extra income. The stock market today is yielding about 2.1%, and many of those bond yields I called off to you are much less than that.
Benz: Jack, you mentioned an intermediate-term corporate-bond index, is that what you would recommend that investors use, if they have that total bond market exposure and they want to emphasize corporates more? Should they just stick with the intermediate duration, or should they maybe stay short?
Bogle: I'd say short and maybe intermediate, and the problem with that is, first of all I'm just going to guess off the top of the head, Christine, 80% or maybe 90% of mutual fund and bond fund investors don't know what "intermediate-term" means. So, you've got to explain it to them, and it's not going to be very different from the total bond market corporate index fund. It's going to be quite similar. But when you say corporate-bond index fund compared with total bond index, including governments, it's an easy explanation. We've made this business of mutual funds awfully complicated. So, I'd strongly lean in favor of creating a new corporate-bond index fund or fixing the index. But you have no idea how difficult it is to change anything that's in place. It's bureaucratic; it involves computer programs. So, I don't think we are going to able to change the Barclays index, but someone ought to be thinking about it.
Benz: And in the meantime, investors can think about maybe changing around their portfolios a little bit.
Bogle: Yeah. In terms of the intermediate-term corporate bonds I would say. And if they're worried about interest-rate risk--which is large today let's make no mistake about that, and further I would not go out long--although the yields are higher, and by the way, this is a perverse business, Christine. If the yield on the long-term bond is higher, say, around 2.8% on the long-term Treasury compared with 1.5%-1.6% maybe on the 10-year Treasury, that is a sign that the long-term Treasury will produce 2.8% a year over the next decade.
The problem with it is, there'll be large fluctuations in value and kind of perverse investor behavior--we hate things when they're going down, we love them when they are high--kicks in. And so it's a self-defeating kind of thing, and anyone that does any of these machinations with their bond funds--I'll be honest, I don't even like to recommend it, because it's complicated, it's frail. I mean will it happen or not? Nobody knows. People have been predicting that bond yields will continue to will go back up and they continue go down.
Benz: That's true.
Bogle: So, it's a hard decision. I think advisors could do a good job by thinking it through a little bit more, but what we should be trying to do for the investor--the investor who we're dedicated to serving, we as an industry or should be dedicated to serving--what we should be trying to do is simplify, simplify, simplify. So, I wish my ultimate hope, if you will, is to have an improved let's say all total bond market index fund for U.S. investors. Call it what you will.
Benz: Jack, well, it's always terrific to hear from you and get your insights. We so appreciate you being here today.
Bogle: Well, have a good bunch of talks about bonds, which are an interesting subject to say the least.
Benz: Thanks for watching. I'm Christine Benz from Morningstar.com.