Wed, 29 Oct 2014
Large foreign government ownership of U.S. Treasuries has overemphasized U.S. government bonds in the Barclays Aggregate Index, says the Vanguard founder.
Benz: You and I have talked in the past about bond indexing and specifically whether the Barclays Aggregate Bond Index, that core bond index that so many index funds track, is a good reflection of the bond market. I'd like to hear your take on that question.
Bogle: First of all, it's been this way from the beginning. You could easily say properly, "Where the heck were you, Bogle, when you started the fund back in 1986?" Then and now, it was about 70% in U.S. Treasuries and government-backed mortgages and so on--the good ones. So, basically, a federal securities position that is creditworthy to the AAA position. It's 70% of the fund now; it was 70% of the fund then. But particularly then, it wasn't all that noticeable because bonds were yielding, I'd say, 7% and the Treasury was yielding maybe 6% and the corporate maybe 8%. So, their yields were extremely generous.
Now, the yield spread is just about double. The 10-year Treasury is now--well, I didn't look this morning, but let me say 2.25%. It's not double, but it's 50% higher for a corporate intermediate. So, you pay a penalty for that in the long run of 1% or 1.5% a year, and that mounts up in a 10-year period--to say nothing of if you're in bond funds for a longer period than that. And that amounts to probably a difference in, let me say, 25%. One and a half percent compounded over 10 years is over 20% in total return. So, I think in the abstract, it's not a good economic deal.
Look, the idea of any index fund, quoting Dr. Samuelson, "is to have you do better than your neighbor." Now, let's look at our neighbors in the government. Well, the total amount in Treasury and government bonds outstanding is $17 trillion. And China, Japan, Great Britain, and a few other countries--mostly China and Japan--own about $7 trillion of that total.
The federal government owns almost $7 trillion of that. Social Security has $3 trillion or so. Those aren't relevant to the average investor in the U.S.; they are just irrelevant. But they are in the index. So, in order to get to the proper position to represent the U.S. bond market, you need to consider what do the pension funds own, what do the banks own, what do the insurance companies own, and what do other individual investors own? And that number comes down, believe it or not, from something like $17 trillion originally to about $5 trillion. I can't do the math in my head, but at that rate, the government-bond position would be, let me say, 20% of the portfolio or 15%. I think around 20% or 25%; there's no magic [number] here for government. That's about right for a portfolio. And this means the bond fund is constantly at a loss to compete with very few, if any, government bond funds. I'll give you an exception to that in a minute. [That goes for] any bond index funds have anything like 70% in governments.
One of the peculiar exceptions, by the way, is PIMCO. They have about 120% in governments, but they've got all of these derivatives. I think they have like a 100% derivative position, buying and selling and offsetting that. I really have never taken the time to analyze it. They are the only one that's all governments, but they do so many things [to offset that positioning]. And another new bond fund--the name escapes me--you would probably know it. The big one that just came out, a spin-off from another bond manager. It's very big. It's a Jeff Gundlach fund.
Benz: DoubleLine Total Return (DBLTX).
Bogle: Yes, DoubleLine. They do all kinds of tricky things with derivatives. Are they going to be right or wrong? I don't know; it's hard to analyze.
Benz: So, I know you've said if investors maybe want to own that Barclays Aggregate Index, maybe they should augment it with a more corporate-heavy bond fund. Would that be your suggestion?
Bogle: Well, the best approach is a simple approach, and that is to describe your marketplace as holdings of U.S. investors in bonds. That's the index--call it "U.S.-held bond funds" or something like that. And the second-best approach is to create a corporate-bond index fund and have that corporate-bond index fund account for maybe half of your bond holdings and, together with the bond-market index fund, you take that 70% [in governments] down to roughly 35%. But it's complicated.
You can also do it very simply and very effectively. [Before,] I would try to get Vanguard to start a corporate-bond index fund, and they just couldn't see it at all. Years ago, they didn't do it. So, we have an intermediate-term investment-grade corporate bond fund, which is basically an index fund; it has a correlation, probably, of 98 with the intermediate-term corporate bond index. You could use that instead of the total corporate bond index to get the same thing because the total bond market is intermediate in maturity. It's got a long, intermediate, and short. But the short and the long just kind of offset each other to give you a total intermediate.
And you could do that, but the way I look at it is from a standpoint of simplicity. So, one of our Vanguard representatives might say, "You could put half of your money in the intermediate-term. People are dying for yield, and you're going to increase your yield by 25% to 30% if you put half of the money in corporate intermediate." If the shareholder says on the phone, "What's an intermediate-term bond?" They don't know. It's just complicated. The total corporate bond fund is easy to grasp. And even though they are both pretty much the same thing, I'd opt for the simpler one. It's been my strategy from the day I started Vanguard, and it's my strategy now. But I haven't been able to persuade anybody else to follow it.
Benz: Just to play devil's advocate: When I look at the performance of, say, Vanguard Total Bond Market Index (VBMFX), to me it looks like it has delivered at those times when I might hope it would deliver. You think of 2002 or 2008--even more recently--the bond market index has done very, very well in periods when equities have not done so well. Isn't that perhaps a defense of the way that that fund is structured?
Bogle: It's a perfectly fair question. I don't want to disagree with it. And I don't disagree with it. But you could have a more effective place to put your bond money, one that's more representative of what I would call the total bond market. And if people are happy with that, [that's fine.] But I look at today's yields, and every investor needs more money. Just about every retired investor can use higher dividends or higher interest paid as dividends. We're just not optimizing that income. It's not terrible. It's a good investment, but I think it can be made better.