by Dr. James M. Dahle, Founder of WCI
“Hate” may be too strong a word, even if it is what prompted you to click on this article. I don’t hate the Total Bond Market Index Fund and ETF (TBM). It can also be an appropriate component of a solid investment portfolio. This is not my favorite Bond choice. Given that the Total Stock Market Index Fund is my favorite mutual fund and that the Total International Stock Market Index Fund comprises a good portion of my portfolio, it’s a bit strange that I don’t like the third member of the “three-fund portfolio.” triumvirate.
However, I think I have some good reasons for this. Want to know what they are? keep reading.
What is Total Bond Market Fund?
First, let’s define what TBM is. We’ll use Vanguard’s Edition (BND) as our example, although there are a handful of other good (and roughly equivalent) TBM funds/ETFs. This discussion applies to all of them. As of May 1, 2022, TBM is a fund that holds a representative selection of the majority of bonds issued in the US by market capitalization and includes:
- 47% Treasuries
- 27% Corporate
- 22% mortgage-backed bonds
- 4% other
The portfolio holds over 10,000 bonds. It has an effective maturity of 8.9 years and an average duration of 6.6 years, and more than two-thirds of the fund is made up of US government bonds (67.5% is US Government, 3.6% is AAA, 2.9% is AA, 12% is A, and 14% is BBB). It has a coupon of 2.9% and a current yield to maturity of 4.3%. It’s available from Vanguard, Fidelity, Schwab and iShares—and is available in both traditional mutual fund and ETF versions.
Problems with Total Bond Market Fund
Now that we’ve defined fund, let’s talk about why I don’t use it.
#1 TBM is not a total
For something that owns “everything”, there are a lot of bonds that are not included in the fund. Here are some mistakes:
- EE Savings Bond
- i savings bonds
- Advice
- junk (high-yield) bonds
- municipal bonds
- foreign bond
- private bond
It’s just a “one-stop shop” if you don’t want any of that other stuff. Imagine if the total stock market fund excluded REITs, tech stocks, and healthcare stocks. Wouldn’t you consider it very “total”? You don’t have to invest in everything, but if you’re going to say you do, you really should.
More info here:
Which Bond Fund Should You Hold?
#2 No inflation protection
The main competitor of my portfolio is inflation. While inflation has been low for most of my investing career, I know that, in the long run, inflation is the most devastating lurking risk to hinder my path toward my financial goals. I built the portfolio from the outset to be as exposed to inflation as possible. Lots of stocks and real estate and even bonds are positioned to offer reasonable resistance to inflation. Now that the risk of inflation has become really visible, people are thinking about it more. However, inflation protection is not new to me, and it is one of the reasons why I do not like TBM.
TBM is very sensitive to inflation. While interest rates have increased over the past several months, you are still losing money to inflation with TBMs.
So, what do I do with my bond portfolio when inflation rears its ugly head? Two main things:
- Put half of my bonds in inflation-indexed bonds like TIPS and I bonds, neither of which are in TBM.
- Keep the duration short to minimize losses due to rising rates and allow the portfolio to earn higher yields quickly when rates rise.
TBM does none of these things. While you can find bond funds that perform worse in an inflationary environment, TBMs are much worse.
#3 Takes risk in favor of bonds
I prefer to take my risk on the equity side where it is more efficient (and not just from a tax perspective.) Corporate bonds (27% of TBM) have inherent equity exposure. When the company is not performing well, the risk of the company going out of business makes the bonds worth less. This risk is not reflected in higher-quality bonds, which are less likely to default. If you’re going to risk companies going out of business, I’d pay more for it. You do this by owning the company, not lending it money. I don’t take corporate risk with my bond portfolio. I only lend money to governments that have the power to tax—either the federal government (G Fund, TIPS, I bonds) or state and local governments (muni bonds). Then, I load up on stocks to take my equity risk off.
If I really want to take risk with fixed income, I prefer to do it with private real estate debt funds and earn 7%-11%, not just 4%-5% (and 2% a year first) that TBM can give. You. The purpose of the bonds in my portfolio is to be safe, so I keep my bonds safe. Relatively low interest rate risk (none with I Bonds and G Funds) and very low default risk.
More info here:
This Is Why I Don’t Keep Bonds in My Portfolio
#4 Owns the mortgage bond
Mortgage bonds seem more attractive than Treasuries and corporates because they offer higher yields. However, there are some inherent risks to mortgage bonds. If rates go down, mortgage holders refinance, and you have to replace your bonds with lower-yielding bonds. When rates fall, they do not increase in value as much as other bonds. When rates go up, no one refinances (or even moves), but you’re still stuck earning lower yields. Only in a very stable interest rate environment do you come out ahead. It seems that we are not in a stable interest rate environment anytime soon. So, why add that risk to your portfolio when it’s so easy to leave it out?
#5 Bad in Taxable
For someone in a high tax bracket who has to keep a good portion of their bonds in a taxable account (i.e. people like me), TBM is less than ideal. Less than half of the funds are in treasuries (which are state and local tax-exempt). Unlike muni bonds, all interest is fully taxable at your ordinary income tax rates. As I write this post, TBM and the Vanguard Tax-Exempt ETF (VTEB) have somewhat similar durations (6.6 and 5.5) and yields (4.3% to 3.2%). If I adjust the 4.3% for my 37% tax bracket, that’s actually a yield of less than 3.0%. Why would I take less than 3.0% when I can get more than 4.0% with less term risk (shorter duration) and less default risk? I will not do.
More info here:
If You Want More Money, You Should Be Rooting For 2023 More Than 2022
Maybe you like TBM. He is alright. As I said, this is a good bond fund, and it can be a very reasonable part of a portfolio. There are many roads to Dublin. But it’s not in my portfolio and probably never will be.
Need to create your own financial plan? Check out the Fire Your Financial Advisor course! This is a step-by-step guide to building your way to financial freedom. Try it risk-free today!
What do you think? Do you invest in TBM? why or why not? What other ways do you invest in bonds? comment below!
Source: www.whitecoatinvestor.com
