Vanguard Offers Four New Bond ETFs

Further to my posting back in January giving details of Vanguard’s low cost (they are kind of like the Walmart of the ETF industry, right?) fixed income ETFs, we got news yesterday of four new offerings:

Vanguard Total Bond Market ETF (BND)

Benchmark: Lehman Brothers Aggregate Bond Index
Holdings: 2,581
Expense Ratio: 0.11%

Vanguard Short-Term Bond ETF (BSV)

Benchmark: Lehman Brothers 1–5 Year Gov’t/Credit Index
Holdings: 710
Expense Ratio: 0.11%

Vanguard Intermediate-Term Bond ETF (BIV)

Benchmark: Lehman Brothers 5–10 Year Gov’t/Credit Index
Holdings: 850
Expense Ratio: 0.11%

Vanguard Long-Term Bond ETF (BLV)

Benchmark: Lehman Brothers Long Gov’t/Credit Index
Holdings: 668
Expense Ratio: 0.11%

There’s no doubt that the appeal for these new ETFs (well, for Vanguard in general) is the low cost. But my feelings on bond ETFs still lead me to believe that the diversification benefits of an indexed bond holding aren’t really that great, especially compared to that among equities within a broad equity index. If having minimal tracking error to a particular bond index really matters to you (then you are likely an institutional investor), then some form of index holding matters. But if you are an institution, you’re clearly not using an ETF or ETFs for your fixed income exposures … well I suppose you could be, but if your board of trustees knew this you should be cleaning up your resume.

Unless you’re a complete novice who can’t build a laddered bond portfolio (or acquire an advisor who can do this), then bond mutual funds or perhaps these bond ETFs should be one of your final options to gain fixed income exposure. It’s almost like the opposite as what might be done on the equity side where you might have a core group of ETFs with stock selection as a “satellite” strategy. For fixed income, a laddered bond portfolio could be the core and fixed income ETFs could be used as “satellite” positions. That might not make sense on a first read especially with regard to the use of bond ETFs. However, I think that we will see a breakthrough in this space where more actively managed fixed income ETF mandates appear as investors continue to push the limits to extract more yield from their portfolios in what is a tough, low-yield world.

Comments

[Beta Hog:]

Richard, please send me ([e-mail]) a message from your personal email address

2007 Apr 11 10:32 AM

[David Jackson:]

Richard, are you also opposed to ETFs versus a laddered portfolio for retail investors? The advantage of an ETF is that it's really easy to buy, can be margined in a margin account, and is easy to sell. And increasingly, it's easy to manage duration using the choice of fixed income ETFs now available.

Very interested to hear your thoughts on this.
David

2007 Apr 11 11:07 AM

[Alan Brochs...:]

I was going to post a similar comment - clearly this is awesome for retail investors. Having been formerly a bond-trader, I always felt bad for the smaller investors who suffered extremely poor liquidity. Indexing in general for the bond market and especially for the small investor seems to make a lot of sense given the inabliity of the industry to generate significant alpha through market-timing or sector exposures.

2007 Apr 11 02:24 PM

[Richard Kang1:]

Like all ETFs or any sort of fund, not every offering is good for every investor. To me the biggest negatives about bond ETFs are the relatively high fees and the lack of diversification provided within the various components in the ETF. Vanguard's offerings significantly take away my first point but because of a lack of competition in this area, it's been a long time coming. Furthermore, in the current economic environment and resulting low total returns, the expenses in bond ETFs hurt even more. The diversification problem still exists however. You really have to agree that within the S&P 500 or other broad market indices, the benefit is that with so many different sectors as well as mix of value and growth oriented stocks, the benefits of diversification are self-evident. The same can not be said to the same degree with bond ETFs.

Of course, DJ and AB, your comments are correct although AB I'm not so sure about the benefits of bond indexing for many retail investors. It's also interesting that despite the fact that, as you say, there's been an "inabliity of the industry to generate significant alpha" in the bond fund space, we're starting to hear of fund offerings that focus on some active management in this area. This includes Sage Advisors working with Ryan ALM on a bond index plus program as well as the well publicized Bear Stearns filing with the SEC for an actively managed ETF. I agree that, at least on the mutual fund front, we have little evidence of alpha generation, but the industry seems to want to go for it in the ETF arena. With preferred share ETFs, dividend focused ETFs and other yield focused fund offerings, perhaps this is another example of the market attempting to provide more than the relatively poor returns found in bond markets in recent years. With the demographic shift (retirement of baby boomers), yield will continue to be a significant objective for many investors. I see it as a parallel to the search for alpha. Product offerings will continue in the ETF space to deal with demand.

2007 Apr 11 03:48 PM

[Andrew Herdman:]

Agree diversification is of less value in fixed income, but precious little alpha outperformance is evident, so it really comes down to costs. The annual expense of an ETF has to be offset by lower administration and transaction costs compared to individual direct investment in bonds. Given retail bid/offer spreads including commission on bonds are typically 30-40 basis points, bond ETF's with annual TERs of 10-20 basis points may well be a more cost effective option. Non-US investors do have to be careful not to be exposed to US withholding taxes. US bonds pay interest gross to foreign investors, but dividend income from a bond ETF may not enjoy the same exemption, suffering a 30% US dividend withholding tax.

2007 Apr 13 01:05 AM

[Richard Kang1:]

AH: Agreed, the income earned from fixed income ETFs would hurt foreign investors more with the withholding tax. Most equity based ETFs are highly tax efficient so it's another argument against the bond ETFs ... and could be significant one depending on investor. I'll be interested to see if the new Vanguard bond ETFs rise to a decent level of AUM and even take some from BGI. Fixed income is one of the areas where BGI will have to consider pricing more carefully and soon. Maybe not their newer bond ETFs but certainly the original treasury ETFs and perhaps AGG and TIP.

I'm sticking to my guns on this one though. For most retail investors = Equity core and explore: ETFs core, stock selection satellite. Fixed income core and explore: Laddered bond portfolio core, fixed income ETFs as satellites.

2007 Apr 13 09:31 AM