Stocks generally provide higher returns than bonds, but bonds serve a crucial role in diversifying portfolios and reducing volatility, particularly during market downturns. Government bonds, issued by the U.S. government, are widely regarded as low-risk investments, whereas corporate bonds, issued by businesses, offer slightly higher returns but come with increased risk.
A major drawback of total bond funds like the Vanguard Total Bond Market Index Fund ETF Shares (NASDAQ:BND) is their composition. Approximately 25% of BND is allocated to corporate bonds, while 50% is invested in government bonds. This blend reduces the overall risk mitigation that bonds can offer in a portfolio.
A superior alternative for many investors may be the Vanguard Intermediate-Term Treasury Index Fund ETF Shares (NASDAQ:VGIT). Given that BND includes corporate bonds, its risk-adjusted returns decline when paired with a broad U.S. equity market fund. VGIT, with its treasury-only holdings, exhibits a lower correlation to the total stock market, offering better downside protection.
Bond Analysis
One effective way to analyze different bond funds is by examining their correlation with the total U.S. stock market. Ideally, bond funds should exhibit low or negative correlation with equities to maximize their diversification benefits. A correlation score of 1 indicates perfect positive correlation, -1 signifies perfect negative correlation, and 0 suggests no correlation.
Correlation Comparison
Historical data from Portfolio Visualizer shows:
Intermediate-Term Treasury Bonds (VGIT): Correlation (-0.01)
Intermediate-Term Corporate Bonds: Correlation (0.46)
Total Bond Market (BND): Correlation (0.24)
This means that corporate bonds tend to move more in line with the stock market, reducing their effectiveness as a risk hedge. Because BND contains corporate bonds, its correlation is higher than a pure treasury fund like VGIT.
Portfolio Testing
A 50/50 portfolio of the U.S. total stock market and each bond fund was tested. The results showed:
VGIT + Total Stock Market: Better overall return and risk-adjusted return.
BND + Total Stock Market: Lower risk-adjusted returns.
Corporate Bonds + Total Stock Market: Highest return but lowest Sharpe ratio.
The key takeaway is that VGIT provides the best risk-adjusted return when combined with a diversified equity portfolio.
The Case for a Total Bond Fund
While VGIT has clear benefits, total bond funds like BND may still appeal to some investors. Here are some considerations:
Higher Expected Returns for Large Bond Allocations
When comparing 100% BND vs. 100% VGIT, BND had a slightly higher Sharpe ratio, indicating that for investors allocating a majority of their portfolio to bonds, a total bond fund may be beneficial.
Expense Ratios
BND has a lower expense ratio than VGIT, though the difference is minimal.
Tax Considerations
Treasury bond interest (VGIT) is exempt from state and local taxes, whereas corporate bond interest (BND) is fully taxable at all levels. This tax advantage may offset the slight cost difference between the funds.
Final Takeaways
For investors looking to build a balanced portfolio combining equities and fixed income, VGIT is the superior option over BND. While BND can provide slightly better total returns in a bond-heavy portfolio, the inclusion of corporate bonds reduces its effectiveness as a hedge against equity downturns.
In summary:
VGIT offers better risk-adjusted returns when paired with equities due to its lower correlation with stocks.
BND includes corporate bonds, which are more correlated to equities and reduce diversification benefits.
VGIT is more tax-efficient, as treasury interest is exempt from state and local taxes.
For investors seeking optimal risk mitigation and portfolio stability, VGIT stands out as the better fixed-income option over BND.