Vanguard Total Bond Market ETF (NYSEARCA:BND) is the premiere destination for a healthy slice of American retirement funds. The instrument, which seeks to represent the movements of the entire bond market, has done well in recent months with record inflows coming on the back of the announcement of a European QE program and nervousness about the stock market.
Why buy into a bond fund?
While it’s impossible to predict what will go on with the Vanguard Total Bond Market ETF, now is the time for investors to evaluate the risks of the instrument, and their attitudes toward it as billions of dollars enters the market looking for stability in a novel, chaotic market.
There’s been huge demand for the fund in recent months and weeks as bonds around the world reacted to coming demand from the European Central Bank. That, coupled with a fear that the stock market has reached a top, is driving the demand for funds like the Vanguard Total Bond Market ETF, but there are weaknesses. Whatever is said about the solidity of bonds, you can lose a sizable part of your original investment, and it doesn’t take a sovereign default to make it happen.
Fighting inflation with the Vanguard Total Bond Market ETF
The big issue with bonds, and this is the worry of many skeptical of central bank policies, is that inflation will wipe out their value, making their paper returns worth much less in real terms. The stock market tends to rise with the rate of inflation, but bonds lose their value directly.
US inflation hasn’t approached 5% since the beginning of the financial crisis, and it hasn’t gone above that level since the early 1990s. Worries that a decade of crisis-born central bank innovations might propel the US economy toward significant inflation have so far proved unfounded. That doesn’t, however, mean that inflation of a high level is impossible. It is, in fact, likely to hit at some time over the next decade.
Investors act on impulse
A fund like the Vanguard Total Bond Market ETF is going to be central to any portfolio that uses debt instruments, and with so much movement in the market in recent months it’s not surprising that so many investors have piled into the fund. Those arguing that a stock market bubble inflated by the policies of the Federal Reserve is the major reason for a bond investment need to take a second look at the facts, however.
Bonds and stock can be correlated and if the Federal Reserve fueled an asset bubble it’s likely to have hit both instruments. There’s no such thing as guaranteed safety in the market, and the total bond market ETFs are no exception to that rule.
Bond ETFs explained
An ETF, or exchange traded fund, is a relatively simple instrument, though it may take a while to get a hang of. An example is the best way to get the specifics across: a treasury bond ETF could be 100 $10,000 bonds, with a total value of $1,000,000 all held by a single agent or fund.
The fund divides its assets up into shares, just like a company on the stock market. The value of each share is arbitrary. This is the same way in which a mutual fund works. With an ETF, however, you can buy and sell the shares whenever you want to whomever you want through a stock market exchange. This lowers the cost and the risk of dealing with the shares.
In this case let’s assume that out treasury bond ETF took the 100 $10,000 bonds and sold 10,000 shares at $100 a piece. This leaves the market open to many more people who could never afford the level of exposure that $10,000 in a single bond would give.
The Vanguard Total Bond Market ETF does basically the same thing as our fantasy treasuries fund except instead of being backed by treasuries it tries to act as a proxy for the bond market as a whole.
