A Solid, High-Quality Choice for Shorter-Term Goals

The following is our latest Fund Analyst Report for Vanguard Short-Term Bond Index VBIRX. Morningstar Premium Members have access to full analyst reports such as this for more than 1,000 of the largest and best mutual funds. Not a Premium Member? Gain full access to our analyst reports and advanced tools immediately when you try Morningstar Premium free for 14 days.

Vanguard Short-Term Bond Fund’s sensible portfolio construction and low price tag is a strong combination that should set up above-average risk-adjusted performance, warranting a Morningstar Analyst Rating of Silver.

The fund tracks the Bloomberg Barclays US 1–5 Year Government/Credit Float Adjusted Index, which offers market-value-weighted exposure to investment-grade government and corporate bonds with between one and five years until maturity. This portfolio keeps its transaction costs low by focusing on the largest and most liquid bonds, and it has tightly tracked its index. But market value weighting leads to a Treasury-heavy portfolio that hasn’t distinguished the fund’s performance from its category peers.

Treasury securities take up more than half of the portfolio. Before the financial crisis, Treasury securities were a smaller part of the fund’s benchmark. However, postcrisis the Treasury market more than doubled to $14 trillion as of 2017, according to Securities Industry and Financial Markets Association data. Accordingly, market-cap-weighting steers the fund toward Treasury bonds. These bonds have low default risk as they are backed by the full faith and credit of the U.S. government. The balance of the portfolio is invested in highly rated investment-grade corporate bonds.

The fund takes slightly more interest-rate risk than its typical category peer, delivering a higher SEC yield than the short-term bond Morningstar Category average. As of July 2018, the fund’s duration was 2.7 years compared with the category average of 1.9 years, making it more sensitive to rate movements than the category group.

Vanguard’s effective portfolio management has produced an outstanding track record. From August 2008 through July 2018, the fund gained 2.13% annually, lagging its benchmark by 0.09% and its category average by 0.30%. This underperformance was due to the fund’s conservative credit risk stance, which helped the strategy to outshine the category average on a risk-adjusted basis, as measured by Sharpe ratio.

Process Pillar: Positive | Phillip Yoo, CAIA 08/29/2018

The fund earns a Positive Process Pillar rating because it accurately captures its target investment universe, which is sensible and investable at a low cost. It effectively harnesses the market’s collective wisdom about the relative value of each bond and tilts toward the most-liquid securities, which mitigates transaction costs.

The portfolio uses representative sampling to track the Bloomberg Barclays US 1–5 Year Government/Credit Float Adjusted Index, which measures the performance of U.S.-dollar-denominated U.S. Treasury, sovereign, supranational, local government bonds and investment-grade U.S. corporate bonds with between one and five years until maturity. Qualifying issues must be fixed-rate and nonconvertible and have minimum outstanding face value of $250 million. Nonqualifying issues include structured notes with embedded swaps or other special features, private placements, and foreign bonds that are traded outside of the markets where they have been originated. This index is weighted by market value and rebalances on the last business day of each month.

Roughly 65% of the portfolio is invested in Treasury securities as there is more outstanding Treasury debt than corporate obligations in the short-end of the curve. However, the fund does not invest in agency mortgage-backed-securities. As a result, the portfolio leans toward high credit-quality holdings. AAA and AA rated securities make up three fourths of the portfolio compared with 50% for an average fund in the category. While these positions limit the fund’s return potential, they protect this fund from adverse market and credit events. Its typical peer allocates less than 20% of its capital to Treasuries and has some exposure to high-yield bonds, which this fund shuns. But its large Treasury allocation has helped the fund endure past market downturns. During the global financial crisis and eurozone crisis, it outperformed 90% and 80% of its peers, respectively.

The fund’s SEC yield was 2.8% compared with the category average of 2.4% as of July 2018 because of its longer duration of 2.7 years. This duration implies that if the rate abruptly experiences a parallel shift by 1 percentage point, this fund could lose approximately 2.7% of its value.

Performance Pillar: Neutral | Phillip Yoo, CAIA 08/29/2018

The portfolio’s three- and five-year annualized returns of 0.6% and 0.9% were behind the category mean by about 100 basis points. Also, its risk-adjusted returns, measured by Sharpe ratio, were below the category average over the same periods. Its underperformance is principally attributable to its larger than average low-yielding government-securities stake.

This large block of Treasury exposes the strategy to sharp rate movements. Recently, when the rate rallied from January to April 2018 partially because of trade tensions, the portfolio was down by about 80 basis points, more than double the category norm. Similarly, during the U.S. election period (August to December 2016), the fund declined by more than 100 basis points compared with the category average of 25 basis points.

Although the fund struggled during the back-half of the decade, its substantial outperformance during 2008, when it beat the category average by 700 basis points, helped the strategy produce an annual return of 2.1% over the trailing 10 years through July 2018. Over the same period, the category returned 2.4% on average. The fund’s risk-adjusted return, measured by the Sharpe ratio, was a little better during that time, besting 60% of its peers thanks to its conservative holdings. Because that showing was in the middle-third of the category, it receives a Neutral Performance Pillar rating.

People Pillar: Positive | Phillip Yoo, CAIA 08/29/2018

An experienced, well-equipped team manages all of Vanguard's fixed-income index strategies, underpinning the Positive People Pillar rating.

Joshua Barrickman was named as manager in 2013. He has worked in investment management at Vanguard since 1999 and managed investment portfolios there since 2005. In 2013, he was promoted to head of Vanguard’s Bond Index Group. While Barrickman does not have an investment in the fund, Vanguard aligns managers’ incentives with investors’ by tying compensation to operational efficiency.

It isn’t practical for bond index funds to own all the securities in their benchmarks, so the managers must use statistical sampling techniques to construct a subset that reflects the key attributes of the index. As a result, manager skill and experience can play an important role in a fund's ability to effectively track its benchmark. Vanguard, a pioneer in index investing, has one of the most seasoned index teams in the industry and has compiled a strong long-term record of keeping pace with the respective benchmarks of its passive index funds. Therefore, key-person risk isn't much of a concern here given the firm's deep bench of portfolio managers and analysts with extensive indexing experience.

Parent Pillar: Positive | 06/05/2018

The Vanguard Group is the world's biggest provider of open-end funds and its second-biggest provider of exchange-traded funds. Innovative and iconoclastic from its mid-1970s origins, the firm's mutual ownership structure, commitment to low fees, and sensible active and passive investment strategies are hallmarks that support its Positive Parent rating.

Vanguard is committed to serving all investors, not just its own. Indeed, the firm celebrates when its entry into an asset class prompts rivals to lower their fees to remain competitive, as occurred when Vanguard launched index funds in London in 2009 and factor-based strategies in the United States in early 2018.

New CEO Tim Buckley, Vanguard's fourth, faces the challenge of expanding the firm's mission to non-U.S. investors, who currently account for less than a tenth of the firm's $5 trillion in global assets under management. He must also navigate the tension between Vanguard's burgeoning discretionary asset-management business, Personal Advisor Services, and financial advisors who may feel threatened by the firm's efforts to lower the cost of investment advice. Perhaps Vanguard's greatest challenge, though, will be keeping pace with its own growth, especially in overcoming the service problems that have bedeviled the firm the past few years. Vanguard's 2017 implementation of client-experience testing labs should help the firm improve there, too.

Price Pillar: Positive | Phillip Yoo, CAIA 08/29/2018

The fund’s Investor and Admiral share classes has an expense ratio of 0.15% and 0.07%, respectively, which makes it one of the lower-cost options in the short-term bond Morningstar Category, underpinning the Positive Price Pillar rating. Both these fees are substantially lower than the 0.55% category average fee. The minimum investment for the Investor and Admiral share classes is $3,000 and $10,000, respectively. There is a separate exchange-traded fund share class that also charges 0.07% without a minimum requirement.

This fund’s index-tracking record has been excellent. From August 2008 through July 2018, the fund trailed the index by 0.09%. This difference is on par with the fund’s expense ratio, displaying the team’s index-tracking prowess.

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