Why A Low Performing Bond ETF Is Good

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—and those percentages might even be worse after correcting for survivorship bias.

Let me explain why I recommend these funds.

These two bond ETFs follow slightly different versions of the Bloomberg Barclays U.S. Aggregate Bond Index, which tracks the investment-grade U.S. dollar-denominated, fixed -rate, taxable bond market. I’ve heard countless times this is proof indexing doesn’t work for bonds. Not so fast, I respond.

Morningstar’s peer group for comparison purposes comprises high-quality, moderate-duration bond funds, which these ETFs certainly are. But the peer group takes on far more credit risk than ETFs that follow this index.

For example, AGG is 64% U.S. government (Treasury and agency) backed, while the peer group averages only 45%. And AGG is 73% AAA-rated versus the peer group of 40%. Most importantly, AGG has 0% junk versus the peer group averaging nearly 6%.

Why Should You Care?

The purpose of bond ETFs is to be the portfolio’s shock absorber. You want your bonds to do well when stocks tank. The more credit risk a bond fund takes, the more it behaves like a stock fund.

In 2008, when stocks plunged, AGG gained 7.9%, while the peer group lost 4.7% and junk lost an average of 26.4%. Then, the 10-year bull began. 2018 was the first year U.S. stocks lost value since 2008, though that loss was small, with the S&P 500 total return (including dividends) losing only 4.38%. Yet in a year with even a small loss, AGG bested its peer group, gaining 0.10% versus the peer group, which lost 0.50%.

The chart below shows how poorly AGG performs relative to peers when stocks have large gains, but also shows how well they perform versus peers when stocks plunge or are even flat.

The bottom line is that you want your bonds to behave differently than stocks. You want to be able to use your bonds to rebalance and buy more equities. In fact, I believe that rebalancing boosts returns. So, if someone tells you bond indexing doesn’t work, don’t fall for it.

My Advice

The past 10 years have been a raging bull market, which is unlikely to continue for the next 10 years. I recommend taking risks with equities and building a boring fixed-income portfolio of high-quality bond funds and CDs. When stocks tank, and they eventually will, you’ll be glad you did.

Allan Roth is the founder of Wealth Logic LLC, an hourly based financial planning firm. He has been a nonpaid panelist at one of NGPF's conferences for high-school teachers, but is not part of its organization. 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.