When Bond ETFs Deliver The Goods

April 03, 2020

The aging bull passed away last quarter—another victim of COVID-19. It was the oldest living bull in history and, even absent all this global pandemic upheaval, would have eventually passed away. Despite a partial recovery, the Vanguard Total Stock Market Index ETF (VTI) has lost 20.85%, including dividends reinvested.

But how did bond funds do? Pretty much as predicted.

High quality bond funds served their role as shock absorber, while taking on any significant credit risk left the investor with losses. Even high credit quality corporate bonds had losses, and high yield (aka junk) had performance closer to stocks than bonds.

 

Boring Bonds Not So Boring

Is this a shocker? I think not. It’s deja vu all over again.

Just like the dot-com and real estate/financial bubbles, taking on credit risk to earn a bit more in interest backfires in down markets.

Just over a year ago, I wrote a piece on why you need a low-performing bond fund in your portfolio. At the time I said:

Sometimes clients are puzzled that I recommend bond ETFs such as the iShares Core U.S. Aggregate Bond ETF (AGG) or the Vanguard Total Bond Market ETF (BND). That’s not surprising, considering that, according to Morningstar data as of Feb. 6, 2019, these two ETFs were bested by 79% and 77% of their peer group over the past 10 years. Thus, these are bottom-quartile funds over 10 years.

I was addressing the widespread belief that indexing doesn’t work with bond funds, which predictably happens in long bull stock markets when taking on more credit risk generally results in higher returns.

Both AGG and BND follow slightly different versions of the Bloomberg Barclays U.S. Aggregate Bond Index, which comprises roughly 63% U.S. government bonds and 37% investment-grade corporates. But you can also see that a pure U.S. Treasury ETF like the iShares 7-10 Year Treasury Bond ETF (IEF) performed so much better. Why? Mainly due to the investment-grade corporate portion of this fund.

Remember Lehman Brothers?

Investment-grade corporate bonds also have risk. Nothing illustrates this risk better than to explain that this Bloomberg-Barclays Index was once called the Lehman Brothers U.S. Aggregate Bond Index. Lehman Brothers, as we all know, went the way of the dinosaurs after the financial crisis of 2008. In fact, just this week, I reviewed a portfolio that had two individual Lehman Brothers bonds.

The false belief that extra returns over high quality bond funds are a free lunch is a painful lesson many of us learn during market plunges. Well, maybe I shouldn’t use the word “learn,” as I’ve seen people repeat these mistakes over and over again.

My Advice

Though many junk bond funds recovered from the last crash, that doesn’t mean the same will happen during this crash. Weaker companies go out of business during recessions and, while the COVID-19 crisis will end, it may take down many companies as casualties.

I’d say take your risk with low-cost diversified index fund ETFs. Put your fixed income in high quality, mostly U.S. government-backed bond ETFs, or FDIC- or NCUA-insured CDs.  

Allan Roth is the founder of Wealth Logic LLC, an hourly based financial planning firm. He is required by law to note that his columns are not meant as specific investment advice. Roth also writes for the Wall Street Journal, AARP and Financial Planning magazine. You can reach him at [email protected], or follow him on Twitter at Allan Roth (@Dull_Investing) · Twitter.

 

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