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By Christine Benz | 04-17-2013 02:00 PM

Bogle: We Need to Fix the Bond Index

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 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.

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