Update by JL’s Team
JL has been receiving a lot of questions about holding VBTLX vs. VMRXX (cash) in today’s era of rising interest rates. We included his comment at the end of this post in our most recent newsletter and figured it would be helpful for the community to resurface this post. If you haven’t signed up for the newsletter, drop your email address in the newsletter signup in the sidebar or at the end of this post to receive a weekly email with new posts, ideas, and resources to help you on your financial journey.
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After a somewhat hidden ~7 year experiment with other bond funds, I returned our portfolio to VBTLX.
Background
Those of you who have read The Stock Series here on the blog, or my book The Simple Path to Wealth, know that I recommend two core funds:
- VTSAX — Total Stock Market Index Fund
- VBTLX — Total Bond Market Index Fund
Both these are Vanguard funds, and Vanguard is the only investment company I recommend for reasons discussed here.
Since these two funds might not always be available in the various tax-advantaged accounts offered by employers, alternatives are discussed here.
Buried more deeply in posts like Part XII: Bonds, and their comment sections, I shared the fact that for the past several years my personal bond allocation was held in funds other than VBTLX.
This information was buried for several reasons:
- Investing in these was an experiment.
- As an experiment, this was not something I was prepared to (and still don’t) recommend.
- But I wanted the information on the blog in the interest of full disclosure.
- By burying it somewhat deeply, I figured only those readers who took the time to thoroughly read (including the comments) and understand the principles here would find it.
- Those readers would be best able to decide for themselves whether following me down this particular rabbit hole made sense for them.
- Who knows what other sneaky stuff I’ve buried around here…
The Experiment
Specifically those other funds were:
- VFIDX
- VICSX
Both are intermediate term corporate bond index funds.
At first glance, intermediate-term funds like these would seem an odd replacement for a total (short, intermediate and long term) fund like VBTLX. But with a total bond fund the short and long term bonds balance each other out and what you have is in fact an intermediate bond fund.
This experiment has been going on for about the past seven years, first with VFIDX and more recently with VICSX. The idea was to seek better yields with a little additional risk.
In this, it has been a splendid success. VFIDX has provided better returns and yields than VBTLX and VICSX in turn has done better than VFIDX.
To understand why I am now walking aways from them and returning to VBTLX, let’s first look at the underlining reasons as to why VFIDX and VICSX have outperformed and then let’s explore why we hold bonds in the first place.
The biggest difference in these funds is that VBTLX holds 64% of its portfolio in bonds from the US Government. VFIDX has less than 7% and VICSX virtually none.
In addition, for its corporate bonds, VFIDX reaches further down the quality ladder and VICSX further still. To be clear, these are not junk bond funds but their holdings are a bit less high quality than those of VBTLX. As we know from our bond post, in exchange for accepting more risk, lower quality bonds pay higher interest rates in order to attract investors.
Now because we always care about costs around here, let’s look at the Expense Ratios:
- VBTLX — .05 ER
- VFIDX — .10 ER
- VICSX — .07 ER, plus a .25% purchase fee (Eek!)
While both VFIDX and VICSX carry higher costs, in both cases their increased yields covered these and then some.
This being the case, why would I turn my back on them now?
Why return to VBTLX?
It is important to realize that this outperformance has occurred during a period of time when falling interest rates and a stable economy has made for smooth sailing for bonds. Since defaults have been few, the risk/return balance has favored the lower quality, higher yielding choices. Indeed, a junk bond fund would have done even better.
Of course, we know some day the road will get rougher and that balance will shift. A price may well have to be paid for taking on that extra risk.
But the more important question is, Why do we hold bonds in the first place?
For those on The Simple Path described on this blog and in my book, it is to smooth the wild and volatile ride of stocks. We are not seeking performance from our bonds, we are seeking a counter-weight to our stocks.
From this perspective, VBTLX is the far better choice. The bond quality is higher and it holds government bonds. Both VFIDX and VICSX tie us to corporate bonds. That is, bonds issued by the same companies we own with our total stock market fund, VTSAX. In a major downturn some of those companies will be pushed to the wall. Some might even default on the bonds we hold from them at the same time their share prices a plummeting. Not a great counter-weight.
But what if…
But what if I don’t want to hold corporate bonds at all? Why not have a fund with only government bonds? Why not go that route?
You could, but for me VBTLX is in the sweet spot. For some, I will always be Too Hot, Too Cold, Not Pure Enough.
But what if the extra potential reward is worth the risk to you? Does staying in VFIDX and/or VICSX make sense then?
Perhaps, but there are better ways to improve performance. The easiest is to simply shift a greater percentage of your asset allocation to stocks. In a bull market VTSAX will soundly trounce both VFIDX and VICSX. Bonds are simply not a great asset choice for maximum performance.
If you want to dial up your performance/volatility, increase your stock allocation. Bonds are for ballast.
So while this experiment has been fun and has worked out nicely for me, the time has come to fold it up and return to VBTLX. Time to let my bonds perform the role I own them for: Smoothing the ride.
Crash coming?
So. Wait.
JL is getting more conservative with his bond allocation. Is this his veiled warning to us the long-awaited crash is coming?
Nope.
As I have said repeatedly on this blog, no one can predict the market.
Over the weekend one of the news programs I watched featured two highly credentialed stock market experts. Both hold high-level positions in top name Wall Street firms. One made the case the market is far over extended and on the verge of collapse. The other, that the market is in the very early stages of a continuing historic rise. Both were articulate and made compelling arguments. One might even be right. Or the host could have found a third to predict, with equally confident reasoning, that the market will go sideways for the foreseeable future.
Easy for you to say, JL. But I’m sitting on a lump sum in cash and this market is at historic highs…
As it happens, I too recently found myself with a substantial lump sum to invest. The lump sum went directly into VTSAX. I don’t like dollar cost averaging and this is how to invest in a raging bull. Although I do confess I half expected the market to collapse the next day just to spite me.
In fact, it was this lump sum investing chore that finally got me motivated also to move our bonds back to VBTLX, which I had been meaning to do for a while now. As long as I hold bonds going forward, this is where they will remain.
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