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This Bond Fund Provides Broad Diversification at a Low Cost

Silver-rated Vanguard Total Corporate Bond ETF is a compelling option.

Vanguard Total Corporate Bond ETF VTC is a great choice for exposure to investment-grade corporate bonds. This market-value-weighted fund is one of the cheapest and best diversified in the corporate bond Morningstar Category, which makes it a compelling option. The fund earns a Morningstar Analyst Rating of Silver.

The fund tracks the Bloomberg Barclays U.S. Corporate Bond Index, which includes U.S. investment-grade corporate bonds with at least one year to maturity. Qualifying issues must be fixed-rate and have at least $300 million in outstanding face value. The index is market-value-weighted, which pulls the fund toward the largest and most liquid issues.

A passively managed, market-value-weighted index fund is a sound approach for exposure to the investment-grade corporate-bond market. It ensures that the fund accurately captures the risk and return characteristics of its opportunity set by free-riding the market's collective wisdom to determine the relative value of each of its holdings. There is less room for active managers to find an informational edge here than in the high-yield bond market because the market knows with greater certainty what investment-grade bonds' future cash flows will be.

There are criticisms against market-value-weighting because it assigns the largest weights to firms with the most debt. While issuer activity dictates the composition of the portfolio, the largest investment-grade corporate issuers tend to have the most resources to service their debt.

Although the fund limits its exposure to investment-grade debt, it courts a fair amount credit risk. As of September 2020, 90% of its assets were rated BBB or A. While this does leave the portfolio susceptible to losses when credit spreads widen, it is an accurate reflection of the composition of the investment-grade corporate-bond market. Some of the fund's peers may hold some below-investment-grade debt, which this fund is prohibited from owning. If the fund's holdings are downgraded to below-investment-grade, it is forced to sell them; this could put it at a slight disadvantage to its active counterparts, as there tends to be considerable forced-selling pressure in those bonds immediately following such a downgrade.

This strategy operates as a fund of funds. Rather than owning individual issuances to mirror the performance of its bogy, it owns a collection of three Vanguard corporate-bond exchange-traded funds. This enabled the strategy to launch with greater scale and ease, but there is a trade-off; it could experience higher tracking error if the underlying holdings are trading at a premium or a discount to their net asset value.

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

Joshua Barrickman was named as manager since its inception in November 2017. He has worked in investment management at Vanguard since 1999 and managed investment portfolios since 2005. In 2013, he was promoted to head of Vanguard's bond index group.

Portfolio management at Vanguard is a team effort, so key-person risk is not a concern. Barrickman leads a team of sector specialists, including a manager focused on government bonds, along with a team that helps with ETF basket creation. These managers are also supported by a team of traders who focus on execution, as well as a data team, which checks incoming index data and helps the managers prepare for upcoming index changes. These teams free up time for the managers to focus on portfolio construction and index tracking. There's also a separate risk management team that independently monitors the managers' performance.

Although fund managers are not required to invest in this strategy, Vanguard aligns managers' incentives with investors' by tying their compensation and performance evaluation to the strategy's tracking error.

Process This portfolio replicates the composition of the U.S.-dollar-denominated, investment-grade corporate-bond market, effectively harnessing the market's collective wisdom about the relative value of each bond. This is a sound approach because it is cost-effective, it promotes low turnover, and the market does a decent job pricing these bonds. It earns an Above Average Process Pillar rating.

The fund seeks to mirror the performance of the Bloomberg Barclays U.S. Corporate Bond Index, which includes corporate bonds with at least one year to maturity. Qualifying issues must be fixed-rate and have at least $300 million in outstanding face value. The index is market-value weighted, which free-rides the market's collective wisdom to find the relative value of these securities. While this allows issuing activity to dictate the fund's exposure, it also accurately captures the characteristics of the investment-grade corporate-bond market.

This portfolio is structured as a fund of funds, owning three Vanguard investment-grade corporate-bond ETFs that span the maturity spectrum. This allows Vanguard to leverage the scale of its existing products and reduce operating costs, which it can pass onto investors.

Portfolio Reflecting the composition of the investment-grade corporate-bond market, the fund courts a fair amount of credit risk. As of September 2020, approximately 51% and 39% of its assets were invested in bonds rated BBB and A, respectively. Those tiers sit at the low end of the investment-grade quality spectrum, which makes this strategy vulnerable to drawdowns when credit spreads widen.

Given that it operates as a fund of funds, this strategy owns individual ETFs as opposed to individual bonds. In periods when the fund's holdings trade at premiums or discounts to net asset value, the fund may exhibit greater index tracking error than if it had held the underlying bonds directly. But significant dislocations are rare and tend to wash out over the long term.

This portfolio is well diversified across issuers, though it tilts toward the financials sector. As of the end of September 2020, bonds issued by firms in the financials sector represented more than 30% of the portfolio. Although the fund could suffer if this sector struggles, its holdings are in line with the category norm. Similarly, the fund's duration of 8.5 years is mostly in line with the category median.

Performance The fund's performance from its inception in November 2017 through September 2020 was solid. It beat the category average by 51 basis points annually with less volatility. Its risk-adjusted performance placed it just outside the category's best performing third. The fund's rock-bottom fee, which is nearly 40 basis points less than the category average, helped its performance.

The strategy also held up much better than most of its category peers during the coronavirus-driven sell-off. Although the fund fell 11.57% between Feb. 19, 2020, and March 23, 2020, it beat the category average by 97 basis points. Part of this outperformance stemmed from its struggle to hang tight to its target index, which lost 12.36% during this period. This was largely due to the wide discounts and premiums of its underlying ETF holdings, as they tended to act as price discovery vehicles in a period where liquidity in the bond market dried up.

The fund's ETF holdings may trade at premiums and discounts to their net asset values, which can contribute to index tracking error. From its inception through September 2020, there have been eight months in which the fund lagged the index by at least 20 basis points, and five months in which it beat it by at least 20 basis points. But overall the strategy has delivered on its objective. On average, it lagged its benchmark by less than 2 basis points per month, and its annual return deviated from the index by 18 basis points between November 2017 through September 2020.

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About the Author

Neal Kosciulek

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Neal Kosciulek is a manager research analyst, passive funds research, for Morningstar Research Services LLC, a wholly owned subsidiary of Morningstar, Inc. He covers fixed-income exchange-traded funds and mutual funds.

Before joining Morningstar in 2019, Kosciulek spent five years as an examiner with the Financial Industry Regulatory Authority, conducting sales practice and financial operational examinations of broker/dealers across the country.

Kosciulek holds a bachelor's degree in economics from DePaul University's Driehaus College of Business. He also holds a Master of Business Administration from DePaul University's Kellstadt Graduate School of Business.

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