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By Christine Benz | 10-23-2014 08:00 AM

Bogle: How Bond Indexing Could Be Better

Large foreign government ownership of U.S. Treasuries has overemphasized U.S. government bonds in the Barclays Aggregate Index, says the Vanguard founder.

Note: This video is being re-featured as part of Morningstar's December 2014 Guide to Better Investment Picking special report. This video originally appeared in October 2014.

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.

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