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Vanguard Total Bond Market Index Fund

Page history last edited by Ken Schwartz 14 years, 8 months ago

Creation Date: 04/26/2008

 

Contents


Introduction

 

Vanguard Total Bond Market Index Fund is the company's most widely diversified fixed income fund, tracking the market-weighted Lehman U.S. Aggregate Bond Index. From the fund's prospectus:

 

"... This Index represents a wide spectrum of public, investment-grade, taxable,

fixed income securities in the United States—including government, corporate, and

international dollar-denominated bonds, as well as mortgage-backed and asset-backed

securities—all with maturities of more than 1 year.

 

The Fund invests by sampling the Index, meaning that it holds a broadly diversified

collection of securities that, in the aggregate, approximates the full Index in terms of

key risk factors and other characteristics. All of the Fund’s investments will be

selected through the sampling process, and at least 80% of the Fund’s assets will be

invested in bonds held in the Index. The Fund maintains a dollar-weighted average

maturity consistent with that of the Index, which generally ranges between 5 and 10

years..."

 

The Fund Holdings page on the Vanguard website reports that as of 03/31/2008, the fund invests in 3372 bonds, while the benchmark index includes 9175. The fund has an average quality of AA1/AA2 and an average duration of 4.4 years. Government mortgage-backed securities represent 37.2% of its assets, while U.S. Treasury and agency debt accounts for 34.9%. The remaining 27.9% is invested mainly in corporate bonds.

 

Share Classes

Three share classes are available to individual investors:

  • Investor (VBMFX), with an expense ratio (ER) of 0.19% and an initial minimum investment of $3,000
  • Admiral (VBTLX), with an ER of 0.10% and a minimum investment of $100,000, except $50,000 suffices for conversion of an Investor Shares account in existence 10 years
  • ETF (BND), with an ER of 0.11% and no minimums, though transaction costs apply in buying and selling through a brokerage

 

Total costs of the ETF and open-end classes may be compared via this Vanguard calculator.

 

Two additional share classes are offered through some workplace retirement plans:

  • Signal (VBTSX), with an ER of 0.10%
  • Institutional (VBTIX), with an ER of 0.07%

 

Advantages

 

Broad Coverage

Because the Vanguard Total Bond Market Index Fund holds a wide swath of the taxable U.S. fixed income market, it is suitable as a core holding for an investor who enjoys sufficient tax-advantaged space or resides in a low tax bracket.

 

Low Costs

Expenses have a more noticable effect on performance for fixed income funds than for equity funds, since fixed income has lower expected returns, as well as less opportunity for managers to impact absolute results. Total Bond Market Index's rock-bottom fees thus serve its shareholders well.

 

Criticisms

 

Misleading Name

Vanguard Total Bond Market Index Fund is poorly named, in that it doesn't come close to covering even the total taxable U.S. bond market. Notable omissions are Treasury Inflation-Protected Securities (TIPS) and high yield bonds.

 

Sector Targeting Acceptable for Individuals

Broad market coverage is far less important for bond investors than stock investors. For example, individuals holding just U.S. Treasury securities, nominal or inflation-protected, incur no credit risk. Short-term Treasury securities (or funds) may indeed be the best stabilizers for an equity dominated portfolio. Alternatively, heavily taxed investors may choose to make exclusive use of high quality municipal bond funds. These vehicles are not quite as safe as Treasury securities even if well-diversified, but the tax benefits are often compelling.

 

Exposure to Call and Prepayment Risks

An index fund, holding a market weight of bonds, does not protect against call risk or prepayment risk. Callable bonds can be redeemed before maturity by the issuer. Bonds are called when interest rates decline, forcing an investor to reinvest the sold proceeds in lower yielding securities. An additional risk of callable bonds is that they are subject to additional capital risks, since changing interest rates can suddenly change the bond's duration (the market will price the bond either to maturity or to the call date depending on the interest rate.)  A similar risk faces investors in mortgage backed securities. As interest rates fall, mortgagees often refinance their mortgages at lower rates, forcing the investor to reinvest at lower rates. Vanguard's Intermediate Bond Index has a similar duration to the Total Bond Index, but does not hold mortgage backed securities. Vanguard's Intermediate Treasury Fund is exposed to neither call nor prepayment risk. [1]

 

Performance

This historical returns webpage provides VBMFX performance for each of the 15 most recent calendar years. During this 1993-2007 period, the fund had an average annualized return of 6.28%. Its best calendar year result was +18.18% (1995), and its worst was -2.66% (1994). Its tracking error relative to its benchmark varied from -2.00% (2002) to +0.26% (1994). Note that the fund's second weakest relative performance was -0.29% (1995).

 

History

Inception dates of Vanguard Total Bond Market Index Fund's various share classes are as follows:

  • Investor: 12/11/1986
  • Institutional: 09/18/1995
  • Admiral: 11/12/2001
  • Signal: 09/01/2006
  • ETF: 04/03/2007

 

The fund was the first retail bond index product offered. Its fortunes hit a snag in 2002, when it underperformed its benchmark by a full 2%. The Vanguard Bond Index Funds' Annual Report of 12/31/2002 discusses the situation.

 

     "To understand what happened during 2002, one must focus on the remarkable turmoil that beset the bond market and the credit ratings of corporate bonds last summer. Here are a few points that illustrate the severity of the bond market's difficulties during mid-2002:

 

  • Lehman Brothers recently ranked the 50 worst credit blowups since 1989. (The list was made up of issues whose bonds had the worst one-month performances throughout the 14 years.) Of the 50 debacles, 32 occurred in 2002--and half of the total in July alone!

 

  • Many companies that suffered financial difficulties saw their bonds' credit ratings fall several notches from investment-grade status to the 'junk' level in a matter of days. Such rapid declines in credit quality struck even relatively healthy companies in troubled sectors.

 

  • By late summer, the returns of Baa-rated corporate bonds--the lowest level of investment-grade issues--were more than 8 percentage points below those of comparable Treasury securities, based on rolling two-month returns. This was by far the biggest gap since Lehman began tracking the returns in 1988. On two other occasions--during the deep recession of 1990 and the 1998 bond market turbulence that was precipitated by the collapse of hedge fund operator Long-Term Capital  Management-- the underperformance of Baa rated bonds approached just 4 percentage points.

 

     Although this extremely challenging market environment does not excuse our funds' shortfalls to their indexes, it does help to explain them. For our funds, the trouble began in June and intensified in July.

 

     As we explained in our report to you six months ago, our funds' returns will typically differ from those of the indexes for two primary reasons: The funds incur expenses that the indexes do not, and the funds' holdings do not exactly replicate those held by the indexes. The expense difference will always work against us in our goal of  providing close tracking. The difference in holdings arises from our 'sampling' approach to indexing, which is necessary because it would be impractical and very costly to own all the bonds in the target indexes.

 

     The sampling strategy--in which we buy some, but not all, of the securities in an index--is  designed to provide our funds with characteristics that are similar to those of their targets. Our portfolio managers and analysts carefully select bonds so that the funds' weightings among sectors closely match those of the indexes. However, during June and July, the relative performance of some 'subsectors'--in contrast to historical experience--diverged widely. At that time, our funds had larger stakes than their indexes in several subsectors. In particular, at a subsector level we had heavier weightings in bonds issued by telecommunications and energy-trading companies. These groups were hit extremely hard by the WorldCom bankruptcy, the Enron scandal, and accounting irregularities at a number of other companies.

 

     In recognition of the radical change in the market's reaction to credit risk, we have made some adjustments to ensure greater diversification and less exposure to lower-quality bonds. For example, we have taken our tight controls on sectors to the subsector level. These changes have already supported closer tracking of our target indexes."

 

Links

Bonds (Local wiki page)

 

Sources

[1] Annette Thau, The Complete Bond Book

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