Bond Funds Overview
Bond Funds Overview
Bonds dampen portfolio volatility and provide current income. A total bond market fund covers 95% of bond investor needs.
Key takeaways
- Total bond market funds (BND, AGG) hold thousands of bonds across government, corporate, and mortgage sectors
- Bond returns come from interest income plus price changes (which depend on duration and rate movements)
- Treasuries offer safety but lower yields; corporate bonds offer higher yields but credit risk
- TIPS provide inflation protection, valuable when inflation is uncertain but costly when inflation is benign
- For most investors, a single total bond fund plus stocks is sufficient; specialized bond funds are satellites
What a bond fund holds
Vanguard's BND (Total Bond Market ETF) and iShares' AGG (Core U.S. Aggregate Bond ETF) are the most popular total bond market funds. BND holds approximately 10,000 bonds across three main categories:
Government bonds (roughly 45% of BND): These include US Treasuries (bills, notes, bonds) issued by the federal government, plus bonds backed by government agencies. Treasuries are considered the safest investments in the world—the US government's ability to print currency means default is nearly impossible. Agency bonds include mortgage-backed securities issued or guaranteed by Fannie Mae and Freddie Mac. These offer marginally higher yields than Treasuries in exchange for slightly higher risk (the risk of early prepayment if mortgage rates drop).
Corporate bonds (roughly 50% of BND): These are bonds issued by companies ranging from investment-grade (highly stable companies like Johnson & Johnson or Microsoft) to high-yield (riskier companies with lower credit ratings). Investment-grade bonds dominate BND. High-yield bonds are typically in separate funds like HYG (iShares High-Yield Corporate Bond ETF) and represent a different risk-return profile.
Municipal bonds (roughly 5% of BND): These are bonds issued by states and municipalities, often offering tax-exempt interest income. For most investors, the tax advantage is not compelling enough to justify lower yields, so tax-exempt bonds are a specialized choice.
Bond yields and duration
Bond fund returns come from two sources: current interest income (yield) and price appreciation or depreciation (duration effects).
The weighted average yield of BND fluctuates with market interest rates. In 2022, when the Fed raised rates from 0% to 4.3%, BND's yield rose from roughly 2% to roughly 5%. The price of bonds fell as rates rose (bonds with older, lower coupon rates are worth less when new bonds offer higher rates). For an investor buying BND in 2022, the low prices and high yields offered an attractive entry point.
Duration is a measure of interest rate sensitivity. A bond with 5-year duration falls roughly 5% when interest rates rise 1%. BND's duration is roughly 6 years, meaning a 1% increase in rates causes a 6% price decline. This duration is moderate—not as volatile as a long-duration bond fund (which might have 20+ year duration) but more volatile than a short-duration fund (which might have 2-3 year duration).
Yield and credit quality over time
As of early 2024, BND offered a yield around 4.5%, providing meaningful income. This is higher than the 2% average yield of the 2010s due to the Fed's rate increases. Future yields depend on the Fed's policy, inflation, and economic conditions.
Credit quality refers to the likelihood that bond issuers will repay principal and interest. BND holds roughly 70% investment-grade corporate bonds (rated BBB or higher by Standard & Poor's) and 30% government/agency bonds. The weighted average credit rating is approximately A (solid, low risk). This is safer than owning individual corporate bonds (where picking a default is possible) but riskier than owning only Treasuries.
How bond prices and interest rates interact
Treasury funds
Treasury funds hold only bonds issued by the federal government. Vanguard offers VGIT (Intermediate-Term Treasury ETF) with a duration of roughly 5 years, VGLT (Long-Term Treasury ETF) with a duration of roughly 17 years, and VGSH (Short-Term Treasury ETF) with a duration of roughly 2 years.
Pure Treasury funds offer the safety of US government backing but sacrifice yield compared to a total bond fund. As of early 2024, VGIT yielded roughly 4% while BND yielded roughly 4.5%. This small yield difference of 0.5% reflects the credit risk premium of corporate bonds in BND.
For investors deeply afraid of recession, Treasury funds can be a defensive choice. During the 2008 financial crisis, Treasury prices rose sharply (rates fell as investors fled to safety), providing a portfolio cushion. However, this safety comes at a cost: lower yields in normal times.
Most investors are better served by total bond market funds like BND, which capture both the safety of Treasuries and the yield premium of corporate bonds, all at low cost.
TIPS and inflation protection
Treasury Inflation-Protected Securities (TIPS) adjust principal and interest payments for inflation. If you buy $10,000 of TIPS and inflation is 3%, your principal automatically adjusts to $10,300, and future coupon payments are calculated on this adjusted principal.
TIPS are valuable insurance against unexpected inflation. If inflation surprises to the upside (say, 5% instead of the expected 2%), TIPS deliver protection that nominal bonds don't. However, TIPS are expensive when future inflation is expected to be low. Currently, TIPS offer a yield roughly 1-2% lower than equivalent nominal bonds.
Vanguard's SCHP (Treasury Inflation-Protected Securities ETF) and VTIP (Short-Term TIPS ETF) provide inflation-protected exposure. For most investors, TIPS are a satellite allocation (5-15% of the bond portion) rather than a core holding.
High-yield bonds: a different animal
High-yield ("junk") bonds pay much higher coupons (5-8%) than investment-grade bonds because they carry higher default risk. During economic expansions, high-yield bonds perform well. During recessions, defaults spike and high-yield fund values can fall 20-30% or more.
HYG, ANGL (iShares Fallen Angels USD Bond ETF), and similar high-yield funds are appropriate only as satellite allocations for investors comfortable with significant volatility in their bond holdings. For most portfolios, core holdings should be investment-grade (total bond market or Treasuries), with high-yield bonds as a small optional allocation if desired.
Bond fund allocation in a portfolio
The stock-bond allocation is the most important decision in portfolio construction. A 60-40 portfolio holds 60% stocks and 40% bonds. A 80-20 portfolio holds 80% stocks and 20% bonds.
For a 60-40 portfolio, the bond allocation would be:
- 60% stocks (divided into 36% US via VTI, 24% international via VXUS)
- 40% bonds (single holding of BND)
No rebalancing needed beyond the stock-international split, since BND handles all bond diversification internally.
This approach is simple and effective. Over the past 30 years, a 60-40 portfolio of stock and bond index funds delivered roughly 7-8% annualized returns with volatility of roughly 10-11%—meaning the portfolio fell only 15-20% in severe crashes like 2008, compared to 50%+ declines for pure stock portfolios.
What bond funds don't do
Bond funds don't guarantee positive returns. In 2022, BND fell roughly 13% as the Fed raised rates. If you owned BND and needed to sell, you locked in losses. This is why bonds are not suitable for money needed within 3 years; stick to cash or short-term CDs for short-term money.
Bond funds also don't provide meaningful defense against unexpected inflation. If inflation accelerates to 6% and bond funds still yield 4%, you're losing 2% annually in purchasing power. TIPS provide some protection, but most bonds don't. This is why bonds are often viewed as a store of value, not a wealth-building engine—their job is volatility reduction and income, not capital appreciation.
Total bond market funds compared
BND (Vanguard Total Bond Market ETF): 10,000 bonds, expense ratio 0.03%, duration roughly 6 years. Excellent core choice.
AGG (iShares Core U.S. Aggregate Bond ETF): Similar to BND with roughly 8,000 holdings, expense ratio 0.03%, duration roughly 6 years. Equally excellent.
SCHZ (Schwab U.S. Aggregate Bond ETF): Similar, expense ratio 0.04%. All three are fine; choose based on your broker.
Related concepts
Next
Bonds and stocks form the core of most portfolios, but retirees and conservative investors often prefer a different approach: target-date funds. These funds automatically adjust from stocks to bonds as you age, eliminating the need to manually rebalance. The next section covers how these "do-it-for-you" funds work.