Vanguard Bond Funds Quietly Get the Job Done

A lot of money has poured into bond funds in the past year, and strong fixed-income performance over the past decade has more than a little to do with it.  Vanguard Total Bond Market Index (VBMFX) gained 6% in the 10 years ended April 1, 2010, while  Vanguard Total Stock Market Index (VTSMX) made no progress during the period despite setting records on the upside and downside in the intervening years. How did Vanguard's fixed-income funds fare in the bond decade, and what may the future hold? For answers, I turned to Morningstar associate director of fund analysis Michael Herbst, who covers many of Vanguard's bond funds. The rest of this article is his work.

Out of Sight, Out of Trouble
Over the past decade, Vanguard's fixed-income operation has avoided the limelight. Indeed, Vanguard's fixed-income crew stands out in part for what it hasn't done. While many asset managers launched a dizzying array of novel bond funds, many of which either collapsed in 2008's market turmoil or have fallen short of expectations, Vanguard launched just one new strategy:  Vanguard Inflation-Protected Securities (VIPSX), which opened its doors in June 2000.

Over the past few years, it has been rolling out a series of fixed-income exchange-traded funds. Some are ETF share classes of existing index funds, such as  Vanguard Total Bond Market ETF (BND) and  Vanguard Short-Term Bond ETF (BSV), while others represent new index funds. For instance, the family recently launched seven new ETFs tracking narrower subsectors of the BarCap Government and Corporate Bond indexes. An ETF share class for the actively managed Inflation-Protected Securities also is in the works.

Battle-Tested
Vanguard's higher-quality emphasis and reluctance to take on big interest-rate bets make the funds' relative performance versus peers' look sluggish when the market thirsts for risk, but shine when the markets head south. There has been one notable exception, though. Vanguard Total Bond Market Index hit a snag in 2002, when management's slight emphasis on corporate bonds backfired in the wake of the World-Com scandal. Ken Volpert's indexing team has since redoubled efforts to lessen the chance of similar misfires through closer index replication and efforts to offset expenses. The fund's 5.96% annualized gain over the trailing decade through April. 1, 2010, lagged that of its Barclays Capital U.S. Aggregate Bond Index by less than one third of 1%.

The year 2008 was no walk in the park for the firm's bond funds, but they avoided the catastrophes that upended peers in all of Morningstar's fixed-income categories. Vanguard's tax-exempt funds withstood unprecedented turmoil in the municipal-bond markets because of their high-quality bias, avoidance of leverage, and smaller doses of interest-rate risk. Shunning esoteric structures and credit risk also helped shield Vanguard Inflation-Protected Securities. The index funds took advantage of dislocations in the corporate-bond markets to more than overcome their operating expenses.

The three investment-grade funds and  Vanguard High-Yield Corporate (VWEHX) steered clear of most of the credit-related potholes that took a heavier toll on (and in some cases crippled) more-aggressive rivals. On the government side,  Vanguard Short-Term Federal (VSGBX),  Vanguard GNMA (VFIIX), and three U.S. Treasury funds under David Glocke's watch flourished as safe havens in the storm. Vanguard's money market funds avoided trouble due to the firm's refusal to reach for yield in prior years and due to the closing of various funds at various times to protect existing investors. Vanguard deserves credit for delivering the protection investors expect from bond funds.

Many of the funds lagged their peers in 2009's junk-fueled rally. Losing less money than the competition has paid off in spades over the longer haul, though. Losses in bond funds are difficult to make up, and the merits of Vanguard's protective approach are evident in the funds' longer-term track records. The vast majority of the funds' annualized returns over the trailing three-, five-, and 10-year periods remain in their respective categories' top half, with many in the top third or top quartile.

What? Low Fees at Vanguard?
No discussion of Vanguard's bond funds would be complete without mention of perhaps their key advantage: rock-bottom expenses. The funds' expense ratios remain some of the lowest around, giving the funds a head start year in and year out. They enable management to deliver competitive returns with less risk. Low fees are one of the strongest predictors of future outperformance and are critical for bond funds, considering the small margins that separate the long-term winners from losers.

More of the Same
At the risk of sounding anticlimactic, part of Vanguard's bond-fund success stems from its lack of radical strategy changes and disruptive management transitions.  Vanguard Intermediate-Term Investment-Grade (VFICX) and  Short-Term Investment-Grade (VFSTX) both began to exercise more flexibility in mid-2004, with greater leeway to own high-quality nongovernment mortgage-backed and asset-backed securities in addition to corporate bonds. As of late, those funds' stakes in securitized assets weighed in at 12% and 22% of assets, respectively. Even though those holdings weighed on the funds' performances in late 2008's downturn, both funds have emerged none the worse for wear.

Management transitions within the fixed-income teams have been gradual. For instance, Chris Alwine recently took over for Reid Smith at  Vanguard Long-Term Tax-Exempt (VWLTX) after working with the municipal-bond team for years. After arriving at Vanguard in the 1990s, Greg Davis and Greg Nassour were named comanagers on the index funds and investment-grade funds, respectively, in mid-2008 and are now working alongside veteran skippers Ken Volpert and Bob Auwaerter. Management transitions at Wellington Investment Management, which continues to subadvise Vanguard High-Yield Corporate, Vanguard Long-Term Investment-Grade, and Vanguard GNMA, also have been deliberate.

A Look Forward
Despite Vanguard's fixed-income success over the past decade, no firm is impervious to stumbles. Another tracking-error mishap on the indexing side would sting Vanguard's reputation. The distant, but not implausible, possibility that the firm would engage a second fixed-income subadvisor in addition to Wellington could also add a dose of uncertainty. As fixed-income investing gets more competitive and more concentrated among a handful of firms, Vanguard needs to prove that it can continue to hire the best and brightest to keep its research and portfolio-management benches deep.

The adage "know what you own" could also help investors manage expectations for Vanguard's bond funds. As of late, four fifths of Vanguard Total Bond Market Index's benchmark was composed of U.S. Treasuries and government-agency debt, so the fund will lag the competition if market sentiment turns against either of those sectors. The family's bond funds also will never try to out-yield their riskier peers. Should persistent inflation fail to materialize, Vanguard Inflation-Protected Securities could have a bumpy ride. Those scenarios have more to do with the uncertain times ahead than the strengths of the funds themselves, but forewarned is forearmed.

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