To Index Bonds or Not?

Miriam Sjoblom, director of fixed-income ratings for Morningstar Global Manager Research, recently caught my attention. For the first time in since forever, she surmised, the 10-year average return for intermediate-term bond funds was above that of Vanguard Total Bond Market Index VBMFX. (This article uses that fund as its example, but it applies to all funds that index investment-grade U.S. bonds.)

Cleverly, I feigned skepticism, thereby spurring Miriam to run the numbers. She returned, vindicated. As shown in EXHIBIT 1, until this summer, Vanguard Total Bond Market Index had beaten its actively run competitors in every trailing 10-year period since December 1999. In June, though, its relative-strength line crossed into the red, and it has been headed down ever since. (The category average includes all funds that existed at the time, even if they have since expired, and it adjusts for the number of a fund’s share classes, so funds that possess many share classes are not overcounted.) The fund’s 10-year Morningstar Category ranking has plummeted, such that the fund ranked in the bottom quintile through October.

Reading It Right That sounds as if catastrophe has recently struck the fund. But rolling-return graphs are often misinterpreted. I have attended several lectures on investment "style drift" at financial-advisor conferences. Inevitably, the presenter shows the evidence from a rolling-return analysis, points to the chart's right and explains how the past two months illustrate management's recent decisions. The audience then nods. It should not.

With rolling returns, we don’t know when the event occurred. For example, a style-drift analysis based on trailing three-year numbers that shows a decrease in a fund’s international-stock position could have indeed occurred last month. However, it also could be that an unusually large October 2015 stake rolled off the study. Similarly, Vanguard Total Bond Market Index’s travails could reflect recent events, or what occurred in 2008.

Ah yes, 2008. That year. It was, as it turns out, an extraordinarily strong stretch for Vanguard Total Bond Market Index’s relative performance. For the calendar year, the index fund gained just over 5%, while the intermediate-term bond Morningstar Category average fell by almost that amount. The result was a 975-basis-point swing in a single year. As long as the fund retained 2008 in its track record, it could trail the category average by a full percentage point in the other nine years of a 10-year period and still finish ahead. In practical terms, it could not lose.

Now it can. It is not as if this fund is performing badly. The apparent collapse of its recent form is just that: apparent. Over the past three months through October, Vanguard Total Bond Market Index has essentially matched the category average (2 basis points behind), and it’s only slightly behind, at 24 basis points, for the year. The rolling-return chart makes 2018 look eventful, but in truth it’s been routinely dull.

That leads us to three questions.

1 What happened in 2008?

You certainly know the first part of the answer. Banks folded, the stock market crumbled, and the bond market froze. Treasury notes traded briskly, but securities not guaranteed by the federal government struggled to get bids. There was, as the cliche goes, a flight to quality. You may know the follow-up, too. (Miriam needed no prompting.) Unusual among index funds, Vanguard Total Bond Market Index looks very different from its typical competitor. An S&P 500 index fund holds somewhat larger companies than does the average large-blend U.S. stock fund, but the disparity is modest. The index fund will go pretty much where the category goes, only more cheaply. Not so with this fund and its rivals. The Vanguard fund is among the highest-quality, most-liquid funds in its group.

- source: Morningstar Analysts

Vanguard Total Bond Market Index invests 41% of its portfolio in Treasuries, compared with 19% for the category average. It makes up for that shortfall by owning issues that, across the board, lagged behind Treasuries in 2008. Sometimes far behind. High-yield debt and commercial mortgage-backed securities, which are barely held by the index, make up almost a tenth of the category’s average portfolio. Those securities lost more than 20% in 2008.

2 Why is the index fund different?

Although Vanguard Total Bond Market Index holds the investment-grade U.S. bond market, and most intermediate-bond funds purport to do the same, the index fund is, practically speaking, another species. Those who run intermediate-bond funds—and who are usually paid by how they perform against the index that underlies the Vanguard fund (the Bloomberg Barclays U.S. Aggregate Bond Index)—systematically underweight Treasuries. That has been the case throughout the trailing decade.

The positive spin for this decision is that, in 2008’s aftermath, active managers realized that risk would pay. As the economy recovered, the lower-quality, less-liquid issues that had suffered the most would rebound the furthest, and they would stay ahead until the next recession. Sound thinking, portfolio managers!

Except, active funds shunned Treasuries before 2008, during 2008, and after 2008. They will always hold fewer Treasuries than does the index. Matching the benchmark’s position would make them like the index fund, only pricier. Exceeding the index’s stake would provide the opportunity for outperformance during flights to quality, but those boons tend to be short and swift; on most occasions, such funds will trail. That is not what active managers wish.

3 Which is better: index funds or the active managers?

For a complete market cycle, probably the indexer. Over time, the decisions of a group of portfolio managers have a roughly neutral effect, so the indexer leads by the size of its cost advantage. Index funds have the advantage unless Treasuries prove to be long-term relative losers.

Shorter periods are anybody’s guess. Treasuries have not served Vanguard Total Bond Market Index well since the 2008 financial crisis, as the rising economic tide has most benefited the lightest boats. Active funds are now ahead for the decade, and they may well retain their lead until the next recession. I would not bet against them. But I would not bet on them, either.

Thinking Strategically The argument in favor of investing in Vanguard Total Bond Market Index today is a cyclical one. The logic: The decade-long economic recovery has helped active funds. When the recovery slows, and recession fears begin in earnest, the index fund will shine. The date of that event is unknown—but this upswing has been long. Best to play it safe by owning the index fund.

- source: Morningstar Analysts

That’s a reasonable angle, but it’s tactical. The decision can be considered strategically. Over a full market cycle, why might one investor hold a total bond market index fund while another might prefer an active counterpart?

Cash Today Many investors, of course, buy bond funds for yield. Even if they reinvest the income distributions, rather than receive monthly checks, they take solace in the knowledge that the fund's profits are genuine. They didn't come because somebody bid up securities one day (only, potentially, to knock them down the next). Rather, the bonds' issuers paid monies to the fund.

If yield is the top priority, Vanguard Total Bond Market Index is not an ideal choice. The index fund’s gross receipts fall substantially short of its typical competitor’s. It makes up much of that lost ground by keeping its expenses very low, but even so, its after-cost yield struggles to match the group average.

The category’s best-paying funds tend to be speculative. (Such is the nature of bond funds.) They partake so heavily in higher-yielding credit—such as midquality corporates, structured credit sectors, and junk bonds—that they aren’t substitutes for a total bond market index. However, a number of successful funds possess both higher payouts and investment-grade credentials. For income-seekers, there are strong, realistic challengers to Vanguard Total Bond Market Index.

Cash Tomorrow Others buy bond funds primarily for total return. Not many do so because they believe that bonds will outgain stocks over the long term (although there are a few such pessimists). Rather, it is because equities are too volatile for their tastes, or they have some stocks already, but enough is enough.

For such investors, Vanguard Total Bond Market Index is a fine choice. Switching the measure from income to total return benefits the index fund in two ways. First, while delving into lower-quality credits will invariably boost yields, it does not always improve total returns. If the capital losses from credit worries outweigh the income advantage, the index fund’s Treasuries will outperform. Second, it is easy to find high-paying funds. It is much harder to identify, before the fact, funds that will post superior total returns.

That said, the relative performance of bond funds tends to be more predictable than with U.S. equity funds (wherein, notoriously, this year’s leader becomes that year’s laggard). Several intermediate-term bond funds have strong 20-year track records. But so does the index fund. From my perspective, the contest is a draw.

Bonds as Insurance Now comes Vanguard Total Bond Market Index's strongest selling point: diversification. Whether the investor favors income or total returns, a bond fund carries the additional purpose of hedging other portions of the portfolio such as stocks, real estate, and commodities. They can lose money, in a hurry. One of the tasks of an intermediate-bond fund is to balance the portfolio.

Vanguard Total Bond Market Index has done just that. Morningstar’s Sjoblom provides the proof. She calculated the correlation between the index fund and the S&P 500, for the almost 12-year period from 2007 through October 2018. It appears in EXHIBIT 2, in gray. However, it does not appear very much, because it is a tiny 0.02. The index fund has not danced with the stock market’s tune.

As the graphic also indicates, Vanguard Total Bond Market Index’s correlation is not quite the lowest. The bottom-decile performers among intermediate-term bond funds average a slightly lower figure, registering 0.01. But it’s close! It is far away indeed from the category median, which is at 0.31. (And further yet from the most correlated funds, represented by the bar on the left.) Clearly, Vanguard Total Bond Market Index offers a strong insurance policy.

When comparing Vanguard Total Bond Market Index with the leading actively run rivals, it falls slightly short on income, is fully competitive for total returns, and comfortably delivers the best diversification. In addition, it would seem to be the timely choice, given the length of the current economic recovery. This, or a similar index fund, is what I would purchase, were I in the market for a bond fund.

This article originally appeared in the Spring 2019 issue of Morningstar magazine. To learn more about Morningstar magazine, please visit our corporate website.