Vanguard Total Bond Market Index Fund
It's exciting to talk about stocks. Fortunes are made and lost with the rise and fall of the stock market. Even for the average individual like you and I stocks, or more specifically index funds serve as one of the greatest wealth building tools. However, having only stocks in your portfolio can be a bit risky, especially if you are getting closer to your retirement age. At various times in your investment journey, you want to add a bit of bonds to your portfolio to smooth out the ride.
In my opinion VBTLX, Vanguard Total Bond Market Index Fund is the one and only Bond Fund you need in your portfolio to help smooth out your investment ride. At an expense ratio of only 0.05%, VBTLX has over 10,000 individual bonds within its fund with varying credit ratings, issuers and maturity dates. So in this post we are going to dive into bonds, what they are, what risks they come with and most importantly why buying VBTLX is your best option for holding bonds.
Bond 101
To begin with, you might be asking, what are bonds anyways? And how do they differ from stocks? Simply, think of bonds as loans. When you buy bonds, you are essentially loaning money to a company or a government agency. Ever heard of US Savings Bonds or Corporate Bonds? Government agencies or corporations issue these bonds, and when they are bought, these organizations are essentially getting a loan from the buyers. Stocks on the other hand are part ownership of a company. When you buy stocks, you are buying a piece of the company itself, not lending it money.
Ok, that’s interesting and all, but why do we want it in our portfolio? There are several benefits that bonds provide that stocks do not. The first reason you want Bonds in your portfolio is that they make our investment road much smoother with its lower volatility. If you were to compare the total stock market trends, VTSAX vs. total bond market index, VBTLX the past 20 years - VBTLX has smaller overall gains, but has much less volatility than the VTSAX.
VTSAX (Blue) vs. VBTLX (Red)
What having bonds in your portfolio will do for you, is that during times of market crash, where your stock investments can dip by 20-30%, your bond investments will hold steady; of course relative to the stock market. It will still have some volatility, just not as much as the stock market.
Now if you are in your 20s and 30s and don’t plan on dipping into your investments anytime soon, having the majority of your investments in stocks is a better move. You have time on your side to ride out the ups and downs of the stock market. However, if you are nearing retirement and want to tap into your nest egg soon, you want bonds in your portfolio. You don’t want to be caught in a situation where you need to pull your money from the stock market when it’s 20-30% down.
Another reason you want Bonds in your portfolio is that they act as a deflation hedge. Inflation and deflation are two big macro risks that impact our portfolio. Inflation is when the price of goods soars and deflation is when the price of goods spiral downward. We are currently in an inflation period, but the market has its own ebbs and flows so we won’t know when we will enter a deflation period again. Being invested in stocks provide us a good hedge against inflation, but we want to be prepared for periods of deflation as well with bonds.
Remember, you want to be long term investors, not market timers. In addition to reduced volatility and deflation hedge, another benefit to holding bonds is that they pay interest, providing additional income flow. Sometimes, these interests can even be tax free with the right bonds; US Treasury Bonds are actually exempt from state and local taxes.
But before you think bonds are all unicorns and rainbows, they have their own set of risks that you want to be aware of. Risks that once you understand, will help you to realize why VBTLX is indeed your best choice when it comes to investing in bonds.
Default Risk
Like I mentioned earlier in the post, bonds are essentially loans to the government or corporations. Responsible organizations, like responsible individuals should ensure they meet their debt obligations. Paying back you, the lender, regularly and on time. However, what happens if the organization is struggling to make its payments and defaults. You as the bond holder won’t get your money back. So in order to help investors evaluate the risks of any company or government bond they are thinking about purchasing, various rating agencies, like the Standard & Poor, evaluate their creditworthiness and give a grade; ranging from AAA to D. Just like school grades, lower the rating, the higher the risk of default.
Now with the higher risk bonds, like double BB and lower, their interest rates are higher because less people would be willing to buy these higher risk investments. So as a buyer of bonds, if you are willing to accept this higher risk, higher the interest rate you’ll receive. Vanguard's Total Bond Index Fund, VBTLX mitigates against this default risk by holding only investment grade bonds. There is no bond within VBTLX rated lower than BBB. Vanguard wants to provide you good returns, but not at the expense of unnecessary risks.
Interest Risk
Interest risk only comes into play if you decide to sell your bond before the maturity date at the end of its term, but it’s a factor you want to consider. Let’s say that you are looking to sell your bond before the maturity date. If the going interest rate has changed since your purchase, the value of the bond will change as well. For example, if the interest rate has gone up since your purchase, the value of your bond will have decreased. Why? Because with the increased interest rate, new bonds may be issued with this higher interest rate making your original bond with a lower interest rate less attractive. If you want to offload it, you’ll need to offer it at a discount. If you are holding onto a few specific bonds with these lower interest rates, you could be at a world’s hurt whenever the interest rate changes. But again, when you hold onto VBTLX, because its holding bonds of widely differing maturity dates, your interest rate risk is mitigated.
Inflation Risk
Inflation occurs when the cost of goods is rising. If you watch any news lately, it seems like all people are talking about is inflation. In my neighborhood, basic food like eggs and chicken are up 10 to 20% compared to what they cost last year. So, if you are lending money by buying bonds during periods of inflation, when you get it back, you can afford less stuff. Last year, I was able to buy a carton of eggs for $2. Now it costs $2.50.
The bond interest rate is set by the anticipated inflation rate. Generally, short-term bonds pay less interest because it's associated with less risk - it's a shorter time horizon and your money is tied up for a shorter period of time. And long-term bonds pay more in interest because of higher associated risk. I know, it can be a bit confusing, but the bottom line is that if you decide to purchase individual bonds, you’ll need to effectively manage this inflation risk. Anticipating what inflation will do in the future and making your associated bond purchase for your portfolio.
Again, this is where VBTLX shines because when you purchase VBTLX, the fund already holds various bonds across a broad range of terms; short-term, mid-term and long-term. Effectively reducing inflation risk. No need to try to predict the future with a magic ball - because honestly, none of us can.
Vanguard Total Bond Market Index Fund
The bottom line is that when it comes to bonds, Vanguard’s Total Bond Index Fund, the VBTLX is really the only fund you need to hold in order to gain all the benefits that comes with holding bonds while mitigating all the risks like default, interest and inflation risks. VBTLX has an expense ratio of 0.05% and its equivalent ETF is Vanguard Total Bond Market ETF (BND). There are over 10,000 individual bonds within this one fund. All with various credit ratings, issuers and maturity dates. Buy VBTLX and start adding them little by little as you get closer to your retirement age. If you want to learn more about Asset Allocation and why they are important for your portfolio, check out my post here.
