How To Pick a Winning Bond Fund

Many investors don’t pay much attention to the bond portion of their portfolio. And that’s not surprising. A Bond fund isn’t very exciting. I suspect most investors’ reasoning goes something like this:

  • If I pick a winning stock fund, my results improve dramatically.
  • If I pick a winning bond fund, my results improve by what, one percent per year?

And they’re right. But they’re overlooking two important facts:

  1. A 1% improvement in performance leads to a big difference in portfolio value after a few decades, and
  2. It’s easy to pick a winning bond fund–much easier than picking a winning stock fund actually.

How should you choose a bond fund?

Simple: Buy the cheapest fund available (as measured by expense ratio) for the type of bonds you want to own. In almost every case, this means selecting a low-cost index fund or ETF.

Of course, sticking with low-cost index funds and ETFs is a great strategy for the stock portion of your portfolio as well. But it works even better when picking bond funds.

If you look at the Standard and Poors Index vs. Active Scorecard from prior years, you’ll see that in most years, somewhere between 30-40% of stock funds outperform their index. In contrast, it’s typical for less than 20% of bond funds to outperform their index.

Related: How much should you invest in stocks vs. bonds

Why is it so hard for bond funds to beat their index?

Two reasons:

  1. Costs consume a higher portion of bond fund returns than stock fund returns, and
  2. There’s little room for bond fund managers to exercise their skill in ways that allow them to gain extra performance.

For example, if the stock market earns an 8% annual return over a given decade, a stock fund manager would have to outperform the market by one-eighth (12.5%) on a pre-cost basis in order to overcome a 1% annual expense ratio.

In contrast, if the bond market earns a 5% annual return over a given decade, a bond fund manager would have to outperform the market by 20% on a pre-cost basis in order to overcome a 1% annual expense ratio. That’s a much higher hurdle to clear.

Making matters more difficult for the manager of an active bond fund is the fact that there’s little he can do to earn above-market returns. Managers of stock funds can exercise their skill by picking and choosing between thousands of different stocks. Managers of bond funds, however, are typically restricted to investing in a very narrow category of securities–U.S. Treasury debt with maturities of 3-5 years, for instance.

In short: It’s difficult for a stock fund manager to overcome a 1% annual handicap from costs, but it’s darned near impossible for a bond manager to overcome a 1% annual handicap. Your best bet is to stick with the lowest-cost fund you can find that owns the type(s) of bonds you want in your portfolio.


6 Excellent Bond Funds

How do you find these low-cost bond funds? The first place to start is Vanguard. It offers several excellent bond index funds with low fees. Here are several of them:

  • Vanguard Inflation-Protected Securities Fund Investor Shares (VIPSX): At 0.20%, this low-cost fund will give you exposure to TIPS, inflation-protected government bonds.
  • Vanguard Intermediate-Term Bond Index Fund Admiral Shares (VBILX): This intermediate term fund is in my portfolio. It charges just 0.07% and offers exposure to a wide range of corporate and government bonds.
  • Vanguard Short-Term Bond Index Fund Admiral Shares (VBIRX): This fund offers two key difference compared to VBILX. First, it invests in short-term bonds, with maturities ranging from one to five years. Second, it’s weighted toward government bonds (70%), with just 30% in corporate bonds. The cost is just 7 basis points (0.07%).
  • Vanguard Total Bond Market Index Fund Admiral Shares (VBTLX): This fund covers the entire U.S. bond market. It includes both government and corporate bonds with a range of maturities. It costs 5 basis points.
  • Vanguard High-Yield Corporate Fund Investor Shares (VWEHX): The most expensive on our list at 23 basis points, this fund invests in corporate bonds. High-yield, also known as junk bonds, invest in corporate bonds of companies with below investment-grade credit.
  • Vanguard Intermediate-Term Tax-Exempt Fund Investor Shares (VWITX): Finally, Vanguard offers several tax-exempt funds suitable for non-retirement accounts. At 19 basis points, this fund invests in municipal bonds, also known as munis.

Note that my list doesn’t include any funds that focus on long-term bonds. Vanguard and others offer these funds. Given the historically low rates today, however, investing in bonds with maturities of up to 30 years is not a smart move.

Tracking Investment Fees

Tracking the costs of your investments can be a challenge. Many people of many mutual funds or ETFs across multiple accounts. The tool that I use is Personal Capital. Its fee analyzer can quickly determine the cost of all of your investments and how these costs will affect your returns.

Topics: Investing

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