Keep Costs Low With This Strong Core Bond ETF

The exchange-traded fund tracks the market-cap-weighted Bloomberg Barclays U.S. Aggregate Bond Index, which includes investment-grade, U.S.-dollar-denominated bonds with at least one year until maturity. The portfolio currently consists of roughly 40% Treasury bonds, 20% government-guaranteed mortgage-backed securities, and 40% investment-grade corporate bonds. Accordingly, it carries low credit risk, which can limit its return potential. However, its cost advantage partially offsets this drawback.

Market-cap weighting tilts the portfolio toward highly rated bonds. AAA rated securities take up about 70% of the fund. The majority of the AAA rated portion of the portfolio is composed of low-yielding, yet secure U.S. Treasuries and agency mortgage-backed-securities. The fund's exposure to Treasuries has increased over the past decade and is now 20 percentage points higher than the category average. However, this fund delivers a higher SEC yield than the category average because it has a slightly more aggressive interest-rate risk profile.

The portfolio's bias toward highly rated securities provides a safety net against market downturns, but it also limits its return potential. The fund's annual return of 4.1% over the trailing 10 years through October 2017 was behind the average return of its surviving peers by 20 basis points. Its risk-adjusted return, as measured by Sharpe ratio, was slightly behind the category average as well.

The managers have kept the fund's performance close to its index. Over the trailing five years through October 2017, the fund trailed the Aggregate Index by 0.08% annually. This gap was in line with its expense ratio of 0.05%.

Fundamental View There is a solid case for investing in a broad, market-cap-weighted bond index, but it isn't as strong as it is for stocks. Market-cap weighting reflects the composition of the fixed-income market, taking advantage of the market's collective view at a low cost. But in contrast to the stock market, many participants in the bond market are not primarily focused on maximizing return. For example, banks and foreign governments hold U.S. Treasuries as a safe place to park their cash, often regardless of the interest rates. Additionally, issuers' financing activities have a significant impact on the composition of the bond market. As a result, a market-cap-weighted bond portfolio, like this one, may differ from how performance-orientated investors invest. That said, fees still matter and many actively managed funds anchor their portfolio to cap-weighted bond indexes.

Bond-indexing is generally more difficult than equity-indexing because of the bond market's sheer size encompassing a vast pool of securities, which in turn prohibits full replication of indexes. It is also more expensive to trade bonds than stocks. The fund's market-cap weighting reduces transaction costs by tilting toward the largest issues. But that approach can also reduce diversification.

The fund offers a slightly higher yield than its typical peer, owing to its longer duration. As of this writing, the fund had a duration of 6.0 years, compared with the category average of 5.3 years. And it has had a longer duration than its typical category peer since 2012, partially because of its heavy exposure to Treasuries. In 2009, the Treasury Department started issuing longer-term bonds to address long-term Medicare- and Social Security-related expenses, while taking advantage of low interest rates. The fund's duration can change over time, since it does not impose a maximum maturity limit and weights its holdings by market capitalization.

The portfolio’s interest-rate risk is partially offset by its low credit risk. Unlike some of its category peers that invest in both investment-grade and sub-investment-grade bonds, this fund is limited to investment-grade bonds. And nearly 40% of its portfolio is allocated to Treasuries. This position is much greater than the category average of 20%. Treasuries accounted less than a fourth of the fund before the financial crisis in 2007-08. After the crisis, however, a record number of long-term Treasuries were issued, and now they take up a significant portion of the U.S. investment-grade bond market.

This low-credit-risk portfolio has tended to trail its peers with greater exposure to corporate bonds in normal to strong credit environments. The fund's underperformance over the trailing five years through October 2017 was principally attributable to the muted volatility of the investment-grade market where its peers reaped rewards for taking on greater credit risk. However, the fund's Treasury-heavy portfolio should insulate investors from large losses during stress periods.

Portfolio Construction The fund employs representative sampling to track the Bloomberg Barclays U.S. Aggregate Float Adjusted Index, a broad proxy for the U.S. investment-grade bond market. The index's composition largely differs from actively managed category peers that focus more on corporate bonds and securitized debt and less on government bonds. However, this broad portfolio effectively diversifies risk, tilts toward the most liquid securities, and promotes low turnover, supporting the Positive Process Pillar rating.

The fund's index includes investment-grade corporate, government, and agency- and mortgage-backed securities denominated in U.S. dollars. However, it excludes ABS and MBS held by the Federal Reserve from its weighting calculations. The securities in the index must have at least one year remaining to maturity and must have $300 million or more of outstanding face value. 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.

Fees The fund has an expense ratio of 0.05%, which is hard to beat, supporting the Positive Price Pillar rating. In fact, this fund is cheaper than 97% of its intermediate-term bond category peers and is substantially lower than the 0.56% category average fee.

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.

There are several Silver-rated, low-cost funds that track the Aggregate Index, which does not exclude bonds held by the Federal Reserve from its weighting calculations. Despite this difference, the composition of this index is very close to BND's. These funds include

Silver-rated

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