Bond Funds/ETFs Can Deliver Meaningful Returns; Cash Can't

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Tom Madell
1.53K Followers

Summary

  • In my July 2020 article on this site, I urged investors to shun money market funds in favor of bonds for the portion of their portfolios not invested in stocks.
  • Over 11 months later, cash has returned close to nothing while bond funds I recommended have returned 3.69%, not annualized.
  • With the Fed on hold, interest rates are unlikely to go up in the near future meaning that bond funds can return at least their dividends, if not more.
  • Finally, I discuss different categories of bond funds and my estimation of their future prospects.

Bonds sign on economy background with graph and coins
Maria Vonotna/iStock via Getty Images

In my July 2020 article on Seeking Alpha, I urged investors who had at least some portion of their overall portfolio parked in cash to reconsider such an allocation and place at least a majority of that cash in bond funds instead. The rationale was clear: cash promised to pay next to nothing over the next two years, thanks to Fed near-promise not to raise interest rates until 2023. Bonds, however, earn a much higher rate of monthly income, and with interest rates pegged near zero, likely won't suffer from damaging drops in price that occur when rates are projected to rise.

Now that more than 11 months have passed since that article, I can now report how bonds did indeed do over the period between the start of July 2020 and June 10, 2021, versus how cash did. Table 1 shows the performance of my own "Recommended Bond Funds." See my Dec. 2020 Seeking Alpha article for earlier data on my "Recommended Bond Funds."

Table 1

Fund (Symbol)

11+ Mo.Tot. Ret.
-Vanguard California Interm-Term Tax-Exempt (VCAIX) 3.42%
-PIMCO Total Return Instl (PTTRX) 1.56
-Vanguard Total Bond Market Index (VBTLX) (See Note 1) -0.44
-Vanguard High Yield (VWEHX) 11.08
-Vanguard Short-Term Investment Grade (VFSTX) 2.32
-PIMCO International Bond (PFRAX) 2.98
-Vanguard Total International Bond Index Adm (VTABX) (See Note 2) 0.23
-Vanguard Inflation Prot. Sec. (VAIPX) 6.52

Note 1: This fund is also available as an ETF, namely BND.

Note 2: This fund is also available as an ETF, namely BNDX

Note 3: The returns shown above are not annualized.

Since December, my "Recommended Bond Funds" have added two new funds. Table 2 shows each and how they have done over the above 11+ month period:

Table 2

Fund(Symbol)

11+ Mo. Tot. Ret.

-Dodge & Cox Income (DODIX)

3.32%

-Vanguard Shrt-TermInfl-Prot Sec Idx Adm (VTAPX) (See Note 1)

5.93

Note 1: This fund is also available as an ETF, namely VTIP.

Note 2: The returns shown above are not annualized.

So how did cash do over the nearly same period from July 1, 2020, to May 31, 2021? According to Portfolio Visualizer, the total return using the Backtest Portfolio Asset Class Allocation tool for cash was a mere 0.07%. By contrast, 7 out of 8 of my original "Recommended Bond Funds" showed positive returns. (And both the newly added funds were positive as well.) The average return for all 10 funds was 3.69%.

Clearly, then, while cash met my December article definition of "trash," bond funds almost always were a better choice for investors. Of course, having some cash might have soothed some investors' nerves in jittery times, and possibly made it easier for them to add to more lucrative performing stock and bond funds as the period progressed. However, unless the Fed is pressured into raising interest rates due to rising inflation causing it to change its mind about it being "temporary," it is reasonable to expect cash to continue to yield the puniest of returns.

How will bond funds perform from this point on? While no one can claim to consistently accurately predict the performance of any investment, I will now do my best to point out the pros and cons of different bond fund investments, including the specific funds listed above.

Municipal Bonds

Given all the talk of higher tax rates for wealthy individuals, and the fact that all investors have very few other places to earn tax-free income, I expect municipal bonds to do well.

In fact, since the election of Joe Biden in early Nov. 2020, while the total bond market funds such as the Vanguard Total Bond Market Index Adm (VBTLX) have had a negative return, all categories of muni bond funds have had modestly positive returns. While long-term tax-exempt munis have done better than intermediate term tax-exempt funds, if interest do rise more than expected in the next year or two, the former bonds will suffer more than the latter.

Investors should keep in mind too that for someone in the 24% tax bracket, the tax equivalent return of the 3.42% return for VCAIX shown above is 4.5%, better than the return achieved by most other bond investments

Diversified Bond Funds

These funds include a mix of different types of bonds, typically of intermediate-term maturities. I include bond funds such as Vanguard Total Bond Market Index (VBTLX), PIMCO Total Return Instl (PTTRX), and Dodge & Cox Income (DODIX), all in my list of "Recommended Bond Funds," in this category.

While these types of bond funds could provide a dollop of positive returns over the next year or two, the trend lately has been not to do so. In fact, any fund with a large percentage of US Treasury bonds, such as VBTLX, is at high risk with government bond interest rates already so low and likely nowhere to go but higher especially if higher inflation forces the Fed to raise interest rates. Funds that are actively managed, such as the remaining two mentioned above, may be able to maneuver around some of the poorer performing bonds and find the best performing assets, which in this case, should be corporate bonds which can at times do well in the strong economy we should witness ahead.

High Yield Bonds

High yield bonds have been the strongest performing category of bonds in the last year and I expect the trend to continue given that investors are starved for yields and are apparently willing to put aside the added risks involved in investing in lower quality-rated bonds. Such bond funds own corporate bonds which can have the advantage mentioned above for such bonds along with lower risk of rising interest rates (i.e. lower duration) as compared to many more conventional bond funds.

Short-Term Bonds

These bonds, such as Vanguard Short-Term Investment-Grade (VFSTX), which are mainly corporate bonds but could also include short-term Treasury funds, while less susceptible to rising rates tend to pay a very low dividend rate. While these categories tend to appeal to very conservative investors or those most worried about rising interest rates, they might only provide marginally positive returns in the next year or two. Most or all of the categories of funds listed here are likely to provide a better return.

International Bonds

With most overseas economies still weak and very accommodative central banks, these should be good conditions for positive international bond performance. However, the year-to-date performance of my above two international bond funds has instead been somewhat negative. Perhaps the explanation lies in the high duration of international bond funds such as these. Just as US focused bond funds with high duration have done poorly, so have these, perhaps in anticipation of a return to stronger growth and higher rates ahead. Both these positive and negative factors cancel each other out making me neutral on these funds' prospects.

Inflation-Protected

This is the bond fund category I am most positive about over the next year or two. Inflation has been a big concern over the last few months or so. Inflation-protected bonds stand to do better than ordinary bonds when inflation is anticipated, assuming it continues to grow in an above average fashion. One precaution, though, is that longer-term fund durations, such as shown in the Vanguard Inflation Prot. Sec. (VAIPX), may be a problem if and when interest rates do rise. While this is not expected for a while, a shorter duration fund, such as the Vanguard Short-Term Inflation-Prot Sec Idx Adm (VTAPX), is a good bet as well.

This article was written by

Tom Madell profile picture
1.53K Followers
Tom Madell, Ph.D., is the publisher of Mutual Fund/ETF Research Newsletter, a free newsletter which began publication in 1999 with thousands of readers. It has become one of the most popular mutual fund/ETF newsletters on the internet, as shown here. His site has been named as one of the "Top 12 Investment Newsletters Focusing on Mutual Funds" at mutualfunds.com , an important fund information provider, under "Fund Newsletter". Also, recently his Newsletter was recognized as one of 5 expert mutual fund resources worth following offering free, and, in its case, particularly "unbiased, useful, and original advice" at http://funds-newsletter.com/fundreference-art.htm .He is also a researcher/writer/investor whose articles have appeared on hundreds of websites, including the Wall Street Journal, USA Today, Morningstar and in the international media.His articles have been among the most popular among those posted on the Morningstar.com website by non-Morningstar employed contributors.His recommendations have an outstanding, long-standing record of success . His complete list of former articles can be accessed at http://funds-newsletter.com

Disclosure: I am/we are long ALL OF THE MUTUAL FUNDS SHOWN. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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