Vanguard Total Bond Market Index Funds

BND and VBMFX?

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Sometimes the names of mutual funds and ETFs can be misleading, and with Vanguard’s “total bond market” funds, that’s exactly the case. Whereas the Vanguard Total World Stock ETF (VT) indeed provides full exposure to the full range of global equities – investing across all geographies and market capitalization ranges – the Vanguard Total Bond Market ETF (BND) and its mutual fund equivalents, Vanguard Total Bond Market Index Fund (VBMFX) and Vanguard Total Bond Market Index Fund Admiral Shares (VBTLX), only cover a fraction of the bond market.

The reason these funds fail to capture the entire breadth of the bond market is that they’re indexed to the Barclays Aggregate Bond Index. This index only covers the domestic, investment-grade portion of the market, including U.S. Treasuries, Agency mortgage-backed securities, and corporate bonds. At the same time, the list of market segments that the index does not include is substantially longer. On the domestic side, the fund doesn’t provide exposure to Treasury Inflation Protected Securities (TIPS), municipal bonds, high yield bonds, or senior loans. The fund also holds no exposure to international bonds, either the developed or emerging markets.

This isn’t necessarily a problem since many investors want the lower risks associated with holding domestic, investment-grade bonds. However, investors in these Vanguard total bond market funds also need to understand that they are not fully diversified in terms of geographies and risk factors and that in reality, they hold only a small fraction of what should truly be considered the “total bond market.”

One reason this is an important consideration is that the types of securities held in the Barclays Aggregated Index tend to have above-average sensitivity to interest-rate movements. This means that when bond yields rise (and prices fall), the value of these funds will as well – an important consideration if the potential for future interest-rate increases by the U.S. Federal Reserve indeed causes the bond market to weaken in the years ahead, as many experts are predicting.

The concentration in interest-rate sensitive securities also means that BND, VBMFX, and VBTLX lack exposure to areas of the market most affected by “credit risk” – high yield bonds and senior loans. Sometimes, this can be a positive – and it certainly is during the times when events cause investors to grow risk-averse and seek the relative safety of lower-risk assets. At the same time, however, it means that investors won’t participate when improving economic growth, rising stock prices, and positive sentiment cause the credit-sensitive segments to outperform investment-grade bonds – as was the case in 2013.

Also, many of the segments not included in the funds are those that tend to provide higher total return potential over time. This means that those who own only a total bond market index fund may be costing themselves some performance – an issue that’s of particular concern to younger investors.

The takeaway here isn’t that the Vanguard Total Bond Market Index funds are a bad option. Quite the contrary: they’re an inexpensive, lower-risk way for investors to add bonds to their portfolio. At the same time, however, don’t let the “total” in the name fool you. In order to get true, total bond market exposure, you will need to supplement this fund with other products to round out your portfolio.

Over time, this need will likely grow due to the expanding size of the senior loan and international corporate bond markets. Keep these points in mind if you’re considering these Vanguard funds as a first step to adding bonds to your portfolio.

Disclaimer: The information on this site is provided for discussion purposes only, and should not be construed as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities. Always consult an investment advisor and tax professional before you invest.