For many younger investors who began their financial journeys during favorable bull markets, the alluring prospects of swift gains often eclipse the lurking dangers of sharp declines.
Guided by optimism and lacking the sobering experience of past downturns, these investors may inadvertently overestimate their own risk tolerance. As a result, their portfolios tend to lean heavily toward equities, leaving them vulnerable during tumultuous times.
Drawdowns, which indicate the fall from an investment’s peak to its trough, offer a reality check. Think back to Black Monday in 1987, when the U.S. stock market nose-dived by about 29%. Or consider the aftermath of the dot-com crash of 2000-2002, which resulted in U.S. stock losses of 44%.
The list continues, with each financial crisis leaving its mark: The 1998 Russian debt default, the 2008 subprime mortgage crisis and the onset of the COVID-19 pandemic in 2020 saw the U.S. stock market dip by about 18%, 51% and 21%, respectively.
In contrast, the U.S. bond market has historically showcased resilience, enduring far lesser blows during these same crises. For instance, bonds only receded by about 2% during Black Monday and about 4% during the financial crisis of 2008.
The trend is evident: Bonds generally offer a cushion during stock market storms. By adding them in a diversified portfolio of stocks, investors can potentially reduce drawdowns, dampen volatility and improve risk-adjusted returns.
When considering bonds, the fixed-income landscape presents its own challenges. Individual bonds, which trade over the counter, can be tough terrain for the uninitiated. Their pricing can be opaque, they’re typically less liquid than stocks and assessing their value can be perplexing for many.
Enter bond funds, which offer investors a ticket to a diversified basket of bonds, without the complexities of direct bond investment. Managed according to various strategies, these funds provide an array of bonds in one consolidated package, spreading out risk and potentially offering more predictable returns.
“Given the higher risks and costs associated with portfolios of individual bonds, and the time they take to manage, most investors are better served by low-cost mutual funds and exchange-traded funds, or ETFs,” says Chris Tidmore, senior manager at Vanguard’s Investment Advisory Research Center. “This is particularly true in the case of municipal and corporate bonds, which are less liquid and harder to purchase than Treasury bonds.”
Here are five great fixed-income funds to buy in 2023, with their trailing-12-month yields as of Sept. 22 (30-day SEC yields will be higher):
|Fixed-income fund||Yield (TTM)||Expense ratio|
|Vanguard Total Bond Market Index Fund Admiral Shares (ticker: VBTLX)||3%||0.05%|
|iShares Core U.S. Aggregate Bond ETF (AGG)||2.9%||0.03%|
|Vanguard Total International Bond Index Fund Admiral Shares (VTABX)||1.9%||0.11%|
|iShares U.S. Treasury Bond ETF (GOVT)||2.4%||0.05%|
|Pimco Active Bond ETF (BOND)||3.8%||0.56%|
Vanguard Total Bond Market Index Fund Admiral Shares (VBTLX)
“The main benefit of bond funds for investors is convenience,” Tidmore says. “Bond funds offer significant time savings over building and managing portfolios of individual bonds yourself, and allow investors to build a broadly diversified bond portfolio with only a few funds.” A great example is VBTLX, which offers exposure to the overall U.S. investment-grade bond market for a 0.05% expense ratio and a $3,000 minimum initial investment requirement.
This mutual fund tracks the Bloomberg U.S. Aggregate Float Adjusted Index, which currently holds some 10,000 U.S. government Treasurys, agency bonds, mortgage-backed securities and investment-grade corporate bonds ranging from one to over 25 years in maturity. With an average duration of 6.4 years, the fund is moderately exposed to interest rate fluctuations. All else being equal, a 100-basis-point increase in rates would cause VBTLX to fall by 6.4%, and vice versa if rates fall.
iShares Core U.S. Aggregate Bond ETF (AGG)
Bonds can also be packaged in ETFs, which trade throughout the day on exchanges. Investors can buy shares of these bond ETFs like any other stock and get exposure to their underlying portfolio of bonds. “Some of the best bond ETFs have low fees, track close to their net asset value, have very tight bid-ask spreads of a penny or less and performance that closely hugs its benchmark,” says Michael Ashley Schulman, partner and chief investment officer at Running Point Capital Advisors.
One of the most popular bond ETFs on the market is AGG, which has accumulated $92 billion in assets under management. This ETF also tracks the popular Bloomberg U.S. Aggregate Bond Index, making its portfolio composition functionally identical to VBTLX. The ETF has an average duration of 6.1 years, and a yield to maturity, or YTM, of 5.3%, which is the theoretical return an investor can expect should all of AGG’s underlying bonds be held until maturity. AGG charges a 0.03% expense ratio.
Vanguard Total International Bond Index Fund Admiral Shares (VTABX)
Diversification isn’t just a principle reserved for equities, as bonds, too, can benefit from an international focus. By venturing beyond U.S. borders, international bond funds like VTABX offer exposure to varying interest rate regimes and the potential for higher yields, providing a buffer against domestic economic shocks, including the unlikely event of a U.S. debt default. The fund is also currency-hedged to mitigate the adverse volatility from foreign exchange rate fluctuations in its underlying bonds.
At present, VTABX tracks the Bloomberg Global Aggregate ex-USD Float Adjusted RIC Capped Index, which holds both government and investment-grade corporate bonds from outside the U.S. market. Countries represented in the fund include Japan, France, Germany, Italy and the U.K. At present, the fund has an average duration of 7.2 years against a yield to maturity of 5.3%. VTABX charges a 0.11% expense ratio and requires a $3,000 investment minimum.
iShares U.S. Treasury Bond ETF (GOVT)
By tweaking the duration of their bond holdings, investors can effectively manage the sensitivity of their bonds to changes in interest rates, thereby influencing both potential returns and risk exposure. Yet, duration is only one piece of the puzzle. Another factor is credit risk. As the name suggests, credit risk relates to the likelihood of an issuer defaulting on their debt obligations. For instance, junk bonds, while offering high yields, come saddled with elevated credit risk due to their higher probability of default.
On the other end of the spectrum are Treasurys, the gold standard for those prioritizing minimal credit risk. The full faith and backing of the U.S. government stands behind these bonds, making them some of the safest debt instruments available. To access a diversified portfolio of about 163 Treasurys ranging from one to 30 years in maturity, consider GOVT, which currently has an average duration of 5.9 years against a 4.8% yield to maturity, all for a 0.05% expense ratio.
Pimco Active Bond ETF (BOND)
Passively managed bond funds strictly adhere to external indexes. While providing low fees and turnover, this structure can also limit their flexibility. Such funds are bound by the rules of their guiding index, curbing their ability to opportunistically target bonds outside the constraints of their index or pivot defensively in reaction to adverse market events. This is where actively managed bond funds like Pimco’s BOND offer advanced investors an alternative.
Thanks to Pimco’s expertise in fixed-income management, BOND has historically outperformed its benchmark, the Bloomberg U.S. Aggregate Index, since its inception. However, it’s worth noting that the active management comes at a price. BOND carries a 0.56% expense ratio, which is steeper than many passive bond funds. And although BOND’s past performance has been stellar, investors should understand that this is never a guarantee of similar future outperformance. BOND has a 30-day SEC yield of 5.2% and a trailing-12-month yield of 3.8%.
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Update 09/25/23: This story was previously published at an earlier date and has been updated with new information.