BSJN - The Best Bond ETFs To Buy Going Into 2024 AGG And BND Don't Make The Cut

2023-12-01 11:23:32 ET

Summary

• The two biggest bond ETFs, BND and AGG, are in my opinion the worst bond ETFs as they lack the precision I want from bonds.
• Unlike with stocks, I believe it makes little sense to simply accept the market average duration if that's not the duration you need or want from your bonds.
• Here I list 3 of my favorite short-term cash yield ETFs, 3 top long-term ETFs, and my preferred ETFs for medium-term bond exposure.

2023 has no doubt been a year when "bonds came back" as an interesting investment in a way I'd argue hasn't been the case since at least the turn of the century. I started this year by arguing that any expected rate of return model for a stock like Apple needs to compare the company's stock fundamentals to the yield on its long-term bonds. The rise in stock prices and bond yields of large cap growth companies like Apple over the course of this year has only strengthened my expectation that large cap growth stocks are likely to underperform their long-term bonds over the remainder of this decade. By summer of this year, I was spending almost as much time on bonds as on stocks, and by October of this year, I easily allocated over 80% of my time and investment purchases into bonds rather than stocks. With the 30-year US treasury yield ( US30Y ) and 30-year TIPS yield ( 30YTIPS ) both now about half a percentage point below their post-2008 peaks last month, I am already regretting not having bought even more bonds last month. Focusing on what I can control, however, I wanted to spend these last weeks of 2023 reflecting on what I expect from bonds vs stocks at current prices, and specifically which US-listed bond ETFs might best reflect these expectations. While it is still my own preference to purchase bonds directly rather than through ETFs, this article aims to provide you a high-level overview of the many different parts of the bond market, and how each respective ETF provides a short-cut to each respective part.

BND and AGG: My LEAST Favorite Bond ETFs

Before listing out my favorite bond ETFs, I find it useful start out explaining why the two largest bond ETFs by assets under management, the Vanguard Total Bond Market ETF ( BND ) and the iShares Core US Aggregate Bond ETF ( AGG ) are my two least favorite bond ETFs. Then, when I list out each of what I consider to be the best bond ETFs to buy, we can compare and see why I consider each of these bond ETFs to be better than BND and AGG for their respective purposes.

In my view, some of the main reasons to buy bonds are for precision, clarity, and certainty on when you will get a certain number of dollars back in the future. When I buy the 3-month treasury bill maturing on 29 February 2024 for $986.67 today, I know I will get back exactly $1,000 on 29 February 2024. When I buy $1,000 face value of the 4% US Treasury bond maturing on 15 November 2052, I know to expect to receive exactly $20 on the 15 of every May and November of every year for the next 29 years until I get my $1,000 back in 2052. If I want to earn a higher yield than treasuries by taking some credit risk, I can choose to allocate some money either to an individual corporate bond or to a bond ETF with the level of credit risk I want to take. BND and AGG on the other, offer the worst of all these worlds by blending together long-term and short-term bonds, treasury and corporate bonds. In a way this takes away that precision, clarity and certainty on when I'll get my money back or what level of credit risk I'm taking.

The published duration and yield metrics of these two funds, currently around six years and a little over 5% respectively for both BND and AGG, provide some guidance on what to expect, but not as much as a direct bond position or most of the other ETF picks in this article. What makes BND and AGG especially unappealing in my view is that "market-weighting" in the bond market simply means investing more into issuers with more debt and less into issuers with less debt, which is probably not the most common sense way to make bond allocation decisions.

Best ETFs for Short-Term Cash

One reason to always have at least one ultra-short term bond ETF on your dashboard is in case you have some excess cash you need to keep liquid and ready to go, without being exposed to the ups and downs of the market, but earning a competitive market rate in the meantime. Here, I list three specific picks:

1. SPDR Bloomberg 1-3 Month T-Bill ETF ( BIL )
2. Dimensional Ultrashort Fixed Income ETF ( DUSB ), and
3. Alpha Architect 1-3 Month Box ETF ( BOXX )

I singled out BIL earlier this year as a much better alternative to simply keeping money in bank deposits, especially in amounts many companies kept at Silicon Valley Bank just before it collapsed. Although they're not the highest yielding short term instrument, it's hard to do better than T-Bills for unlimited security of US dollars, plus the interest may be exempt from state income taxes for residents of states that charge those.

BIL is one of those ETFs that at first seems useless, because I could just buy 1-3 month T-Bills directly myself with the exact maturity I want, though BIL does conveniently handle the automatic reinvestment into new bills if you need to keep the money in there for longer. For its 0.14%/year expense ratio and $35 billion size, I'd think they'd also have the budget to start adding more banking features like a debit card and direct peer-to-peer payments so that I don't even need a bank account, but for now that's just wishful thinking.

Back to the primary reason for keeping short-term cash in something like BIL instead of BND or AGG, this next chart shows the maximum drawdown off the total return high of BIL vs BND and AGG. While BIL is there primarily to avoid drawdowns, BND and AGG are down over 13% each from their highs, and $100 put into either back in 2020 still seems to be a long way from getting back to even.

If we zoom in on BIL, we can see that BIL is also not 100% immune to drawdowns, and anyone putting serious money into BIL should understand these drawdowns. The biggest drawdown in BIL so far seems to have maxed out in late 2015 at around 0.75%, and my best explanation for this is that BIL was invested in T-Bills yielding literally zero for five years, minus its 0.14% expense ratio per year, by that point. Once the Fed started hiking rates in 2016, the 1-month ( US1M ) and 3-month ( US3M ) T-bill yields become high enough to cover the expense ratio of this fund until 2020-2021, when once again we saw zero interest rates leave this fund with a negative net yield.

My second best short-term bond ETF pick is DUSB, which only launched in late September 2023. I have long been a fan and power user of Dimensional funds, and use several of their equity ETFs to cover the small cap corners of my portfolio, and am equally impressed with how they have applied their expertise trading small cap equities to trading less liquid fixed income. DUSB differs from BIL by investing not in T-Bills, but rather in short-term investment paper issued by banks and foreign governments which I can fairly expect to net about 0.5-0.8% per year above BIL. As of now, Dimensional reports DUSB as having a 30-day SEC yield of 5.74% and a portfolio yield to maturity of 6.22% with a duration of 0.65 years (about 8 months). By comparison, 6-month US T-Bills ( US6M ) yield 5.42% as I write this. What I expect, and plan to continue watching, is that Dimensional's flexible trading approach can help deliver a net return on the higher end of that range, and for that, I'm very happy to pay DUSB's slightly higher expense ratio of 0.15% per year. I should note though, that I do not pay any US state income taxes, while someone living in California or New York may find the net after-tax yield on BIL a better deal.

My final pick for best high yield cash ETF to buy is BOXX, which differs from BIL and DUSB thanks to a tax loophole which may allow BOXX's returns to be treated as capital gains instead of as interest . BOXX does this by investing cash in 1-3 month listed option strategies called box spreads, which sound fancy, but they're effectively just a 1-3 month deposit with the options exchange paying a market rate of interest like BIL or DUSB, regardless of what the market does in that time. The BOXX website currently reports a yield of 5.71% with a duration of about 0.22 years (= 81 days), which makes it competitive with BIL and DUSB and probably worth the higher 0.19% expense ratio if you like the tax treatment. The main advantage I see in earning money market yields in the form of capital gains is so that I can offset them against realized losses, which I am usually able to harvest from somewhere in my portfolio in most years. In other words, if I can realize a $5,000 loss on one stock in my portfolio, then earn $5,000 in gains from BOXX, I expect to offset the latter with the former and effectively earn that $5,000 in interest on my BOXX deposit tax-free.

Best Long-Term Bond ETFs To Buy

On the opposite end of the curve are ultra-long term bonds, which is where much of my buying in October 2023 was focused. This is where I found it useful to be able to buy bonds directly rather than through ETFs, since few if any ETFs focus mostly on bonds maturing in more than 30 years, which are the bonds I was most interested in buying as their yields hit 6%. Just one example of these ultra-long bonds is the Apple 4.1% of 2062 , whose yield peaked out at 5.9% in October, but as mentioned at the start of this article, I still consider this bond quite likely to outperform Apple stock in the medium term. My three top long-term bond ETFs to pick as of late 2023 are as follows:

1. PIMCO 15+ Year US TIPS ETF ( LTPZ )
2. PIMCO 25+ Year Zero Coupon Treasury ETF ( ZROZ ), and
3. Vanguard Long-Term Corporate Bond ETF ( VCLT )

LTPZ is my natural starting point for long-dated US bonds, because the biggest real risk from investing $1,000 into a 30-year bond is the loss of purchasing power of that $1,000 over such a long period. As mentioned at the beginning of this article, this is why I was excited to see that most of the rise in US30Y this year was due to a rise in 30YTIPS, meaning most of the extra yield I can expect to earn from buying bonds this year is a real yield over and above inflation expectations. I see real interest rates of over 2% as unsustainably high for any developed economy with aging demographics, even the US, which is why I'm quite comfortable buying more long-term bonds as long as 30YTIPS remain above 2%. LTPZ is the purest ETF for capturing just the real portion of this yield while maintaining the full inflation hedge of US government issued inflation-indexed bonds. As of now, I see LTPZ reporting a duration of 19.3 years versus that expected real yield of just above 2%, or nominal yield of around 4.4%.

One contrary risk faced by investors in LTPZ is the risk of deflation, which I don't believe enough investors are worried about now. One market that has fascinated me since the 1980s is Japan, and one of my base case scenarios is that many western economies will become more and more like Japan as we age, with deflation becoming the bigger threat than inflation. If US inflation were to collapse to zero and remain there for a long time, as Japan has shown is possible, then LTPZ would only deliver that ~2% real return, while ZROZ would deliver its full nominal rate of return, which is currently around 4.4%. In other words, ZROZ may be the most concentrated form of "insurance" against a deflationary depression scenario like that seen in Japan over the past 30 years.

My final pick for the best long-term bond ETF is VCLT, which I see as more of a long-term buy and hold play for retirement plans and other tax-sheltered, income-paying accounts. VCLT provides that long duration exposure with the added yield earned from a diversified portfolio of investment-grade corporate bonds, which I usually expect to net about 1% per year more than treasuries over time. About 0.06% of VCLT is invested in that 2062 Apple bond mentioned earlier, and there is a total of 1.45% of VCLT invested across 22 Apple bonds maturing almost every year from 2041 to 2062. Multiply that by dozens of different issuers, and you can see that VCLT is a very diversified portfolio of high-quality long-term fixed income sources well suited to paying out a pension. As of now, Vanguard reports a portfolio yield to maturity of 6.54% with a duration of 12.1 years, so falling yields may be a bigger concern for longer-term retirement accounts holding VCLT. As with other Vanguard ETFs , one of VCLT's advantages is that it's very cheap with an expense ratio of only 0.04%, far lower than even BIL.

This next and final chart may be a bit counter-intuitive, but is one I hope will show why I would strongly prefer to buy any of LTPZ, ZROZ, or VCLT over BND or AGG. Over the past six months, over which October 2023 was probably the most dramatic spike in yields, ZROZ dipped more than LTPZ, which dipped more than VCLT, which in turn dipped significantly more than BND or AGG. This is simply because ZROZ has a longer duration than LTPZ, which has a longer duration than VCLT, which has a longer duration than BND or AGG.

The flip side of this duration was seen during the COVID crash of early 2020, when ZROZ and LTPZ both rose significantly on the collapse in yields. VCLT did not rise as much in value because the credit spreads of long-term corporate bonds also widened on fears that more of them would go bankrupt, which is of course why corporate bonds yield more than treasuries. For the scenarios where I expect yields to continue falling from their recent highs, I would much rather have the longer duration of LTPZ, ZROZ, or even VCLT than BND or AGG.

One Good Medium-Term Bond ETF To Buy

In most of this article, I have focused on either ultra-short term bond ETFs to compete with your high yield savings account, and ultra-long term bonds to provide the maximum amount of true bond exposure (duration) per dollar invested. For investors that truly want medium-term bond exposure with a duration closer to that of BND or AGG, I also have a set of bond ETFs I strongly prefer in this range: Invesco's BulletShares or BlackRock's iBonds . Of these fixed maturity bond ETFs, I pick just one as an example: the Invesco BulletShares 2028 High Yield Corporate Bond ETF ( BSJS ). My reasons for picking this specific one as an example are:

1. 2028 is the year of my 50th birthday, and I specifically want to set aside a specific sum of money for that specific goal, and not have to worry about where the market is when those bonds mature.
2. I chose the High Yield series because I am happy to take some credit default risk in exchange for the much higher gross yield of around 8% on this bond portfolio. Net of these defaults, I reasonably expect BSJS to net around 7% per annum until 2028.
3. I chose the Invesco BulletShares over the BlackRock iBonds for one simple, and arguably frivolous, reason: Invesco shows the credit rating of each bond in the holdings file I download from their site, while the iBonds download file does not.

The value of having that fixed maturity date for a fixed goal is probably best illustrated by one final chart below, which shows how the high yield BulletShares maturing this year in 2023 ( BSJN ) would have met a 2023 goal over the past several years compared with the same amount of money invested in BND or AGG.

Conclusion

This article largely aimed to outline three different uses for bonds, and why I believe using a specific bond ETF for each of those uses is better than buying a more general bond ETF like BND or AGG. For short-term cash whose value you want to preserve while earning market rates of interest, BIL, DUSB, and BOXX are my current top picks. If what you really want is bond beta, i.e. duration, then $1 invested in LTPZ, ZROZ, or VCLT will get you a lot more bang for that buck than the same $1 invested in BND or AGG. And finally, if you have a specific goal with a medium term duration of 2-10 years, and need to use an ETF rather than direct bonds, then fixed maturity solutions like BSJS are a much better solution in my opinion.

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