2024-01-19 13:09:44 ET
Summary
- The Vanguard Total Bond Market ETF's 16% loss over the last 3 years exposed the flaws in advisor's long held belief that "Bonds are for Safety."
- Many investors believe that they will be made whole in a length of time corresponding to the ETF's duration. This is not true.
- BND's index methodology forces it to sell bonds before they mature, locking in losses after rates rise. We examine this methodology in some detail.
- Rising defaults for BBB- rated bonds pose another threat to share price recovery as does the callability of many of the ETF's holdings.
When the Federal Reserve raised its overnight rate from near 0% to 5.25% holders of the Vanguard Total Bond Market ETF ( BND ) suffered significant losses that came as a painful surprise to those who had subscribed to the common claims that "bonds are for safety" or "bonds are the ballast for your portfolio." After 40 years of steadily declining interest rates, investors had forgotten the simplest rule of bond fund pricing: the duration of the fund tells you, approximately, how much your fund's NAV will decrease with every 1% rise in interest rates.
And when we say "investors" we are not just talking about naive retail dabblers. Lots of the folks who run banks apparently forgot this too, as evidenced by the issues faced by banks like Schwab ( SCHW ) that were caught sitting on huge holdings of long, low-yielding loans and bonds.
Financial advisors also seem to have had a blind spot. Any client who answered the simplistic questionnaires used to define how much "risk" a client should take on with answers that put them into the "conservative" category would be put into a 40/60 portfolio with the 60% invested in bond funds, usually intermediate duration bond funds like BND.
BND's Share Price Decline Is More Durable Than Many Stock Crash Losses
Those who understood how bond funds work could easily see that when bond rates eventually rose away from the zero bound that was the legacy of the 2008 Financial Crisis, BND would take a beating. BND's duration has hovered around 6.0 for as long as I have tracked it. It is currently at 6.4.That means its share price would have to drop about 6% for every 1% rise in rates. Here is what has happened to the price of BND over the past three years.
BND's NAV Lost 16.81% over The Past Three Years
The decline in BND's NAV over this period matches quite closely what its duration would predict. Its yield back in 2021 was somewhere around 1%.
The Rise in Yield Due to the Rise in Overall Rates Lags the Decrease in Share Price
It is common to see investors in bond funds assuring each other that the rise in rates that accompanied the plunge in bond fund share price means that investors are already benefiting, but much of that rise in yield is only because bonds paying the same coupon they paid three years ago are now marked to market at much lower values.
That's why while BND's actual distribution yield has risen, it has risen far less than investors may think if they visit Vanguard's BND page and see that it displays BND's SEC yield as a hefty 4.26%. This may make investors think that by buying BND now they are going to lock down that 4.26% yield, but this is a dangerous mistake, akin to thinking that "Bonds are for Safety."
Seeking Alpha tells us that BND's Trailing 12 Month Yield has been 3.12%. though this yield covers all of 2023 when the 5 and 10-year Treasury Rates went up as high as 5% and you could have locked that rate in safely with no fear of losing capital by buying individual bonds.
The problem with the SEC yield. as you will learn if you click on not-at-all obvious small gray line of text above the SEC yield, is that the SEC yield is a "hypothetical yield." Vanguard's note warns,
This hypothetical income will differ (at times, significantly) from the fund's actual experience; as a result, income distributions from the fund may be higher or lower than implied by the SEC yield.
What they don't mention is that the SEC yield is typically lower than the actual yield you will get when rates have been in a long period of steady dropping, but that they are higher than what you will receive after a period when rates have been rising, as is the case today.
Vanguard does not report the distribution yield for any of its ETFs, but since BND is a share class of Vanguard's Total Bond Market Index Fund ( VBTLX ) we can see what the most recent current distribution yield is for the fund has been, which should be almost identical to that of BND. The most recent distribution yield from VBTLX, dated December 29, 2023, was 3.40%, which is 20% less than its SEC yield given as of December 31, 2023.
Vanguard's Presentation Minimizes BND's Actual Poor Performance
The devastation suffered by investors in BND is hidden by the way that Vanguard reports its performance. Its currently displayed Price Performance charts only go back 18 months, to August of 2022, by which time the Federal Reserve's overnight rate had already risen 2.50% leading to the precipitous drop in its share price!
For longer periods, Vanguard only reports Total Return. This is a metric which assumes that any interest paid is reinvested. It is also calculated in a way that makes the devastation wreaked on BND's share price, which we saw above, pretty much disappear.
How Vanguard Depicts BND's Longer-Term Performance
A naive investor might be lulled into thinking that BND has been reasonably safe investment, if all they saw were these figures. If the worst return over the past 10 years is only a loss of 3.36% and the fund is up 5.70% over the last year, it sounds like BND is still as safe as houses.
But what is lost here is this: investors who bought BND at any time before January of 2021 will suffer a painful capital loss -- somewhere around 16% -- if they have to sell shares to recover principal, as BND's share price is still down dramatically from what they paid back when the Federal rates were near 0%.
If You Hold For The Duration You Will Not Be Made Whole
If you buy an individual bond, be it a Treasury, Corporate, or Agency, you will get back all the principal you invested at maturity no matter what rates have done during the time you have held it as long as its issuer hasn't defaulted. This means you can ignore the mark-to-market price your brokerage assigns to your bond holdings daily.
Based on what I have read in many online discussions on Bogleheads and various Reddit investing groups many investors seem to think that if they hold a bond fund or ETF for the number of years corresponding to its duration they will also get back what they invested. But this is not true.
The reason for this is that bond index funds and ETFs do not hold their bonds until they mature. They are continually selling bonds before maturity and buying new bonds only when they are issued. Vanguard reports BND's Turnover Rate for 2023 as 39.90%.
The Index BND Follows Sells Bonds with Less than 1 Year Left until Maturity
To understand this turnover we need to look past what Vanguard tells us and examine the construction of the index that BND follows, the Bloomberg US Aggregate Float Adjusted Index. This index is a custom index used only for BND. It is a variation on the widely tracked Bloomberg US Aggregate Index. Bloomberg does not make public a separate document describing how the float adjusted version of this index is constructed, but its overall index methodology document notes on Page 5 that it is a version of the US Aggregate Index that "excludes securities held in the Federal Reserve System Open Market Account."
When we look at the public document describing how the US Aggregate Index is constructed we find out that the bonds it holds must have at least one year left to maturity. As defined in the document describing the methodology of the Bloomberg US Aggregate Index, the maturity of bonds included in the index must have,
• At least one year until final maturity, regardless of optionality. • MBS must have a weighted average maturity of at least one year. CMBS and ABS must have a remaining average life of at least one year. • Bonds that convert from fixed to floating rate, including fixed-to-float perpetuals, will exit the index one year prior to conversion to floating-rate. Fixed-rate perpetuals are not included.
That implies that the index BND follows must sell all its bonds a year before they reach maturity. Taking this further we see that in 2022 the fund would have had to sell all its bonds maturing in 2023 and by the same token in 2023 it would have had to sell all the bonds maturing in 2024. All of those bonds would have been issued at rates lower than what prevailed in 2023 and 2024, so they would have been sold at a loss, locking in the losses of BND shareholders.
BND Must Sell Bonds that Drop Below Investment Grade
There is another reason why bonds held by BND's index must be sold: if their credit quality drops below investment grade. From the US Aggregate Bond Index document we see this clearly stated:
Securities must be rated investment grade (Baa3/BBB-/BBB- or higher) using the middle rating of Moody’s, S&P and Fitch; when a rating from only two agencies is available, the lower is used; when only one agency rates a bond, that rating is used. In cases where explicit bond level ratings may not be available, other sources may be used to classify securities by credit quality
The index is rebalanced at the end of every month, so the selling of bonds with only one year of maturity left occurs 12 times a year.
And this is where we start to see why, no matter what happens with the Federal Reserve's rate going forward, BND has the potential to suffer more, serious, losses in the value of its holdings.
Vanguard tells us that as of the end of 2023, 13.56% of BND's holdings were rated BBB. Note that Vanguard lumps BBB, BBB+ and BBB- rated bonds together in one category as it does with the other rating levels. These BBB bonds represent 41% of all the corporate bonds held by BND. This is the very lowest rating that still qualifies as Investment grade. Any decrease in the ratings of these bonds will require that they be sold, no matter how many more years they have until maturity.
We also know that, as investors discovered back in 2008, bond ratings may be stale and not reflect recent changes in the credit quality of their issuers. BND holds another 12.70% of corporate bonds rated A, a step up from BBB.
Remember that BND is following an index, which is passively constructed. There is no human eyeball reviewing each of the 10,719 bonds the index holds. Sudden changes in the credit quality of a company may occur before a corporate bond's rating is changed, meaning that by the time the index's algorithm notices that the official rating of a bond has dropped into the Junk category making it necessary for the index to sell it, its price may have already dropped dramatically.
BND Buys New Bonds Only When They Are Issued
When the index sells a bond it does not immediately replace it with a new bond paying a higher coupon. I see this stated all over Internet discussion boards. But if you read the methodology document you will see that the index adds new bonds when they are issued. So it is possible for it to sell more bonds than it buys, or to buy more short term debt to replace long term debt it has been forced to sell at a loss because it has sunk to a junk bond rating.
The Likelihood of Corporate Bond Default is Rising
A recent Seeking Alpha news article notes that defaults of bonds rated BBB- and lower have been rising. When bonds default, investors may recover only a small portion of the value of the bond, or even nothing at all. Those BBB bonds Vanguard reports holding include BBB- rated corporate bonds, Vanguard lumps the BBB- category with BBB on its BND product page. Those BBB- bonds are included in the Bloomberg US Aggregate indexes. So it is quite likely that BND's NAV will reflect the loss of those defaulted bonds over the next year or two. It is hard to know what they will be replaced by.
Vanguard breaks down the maturities of its holdings, but it does not break them down by the various quality ratings. This means we don't know how much of the poorer quality bonds that BND holds have long maturities. This is important because the longer the time left until a bond matures, the lower its current price is when rates have risen. So a BBB- bond that has four more years until it matures is going to sell for a far lower price if its rating drops to junk than a BBB- bond will that matures in 2 years.
We Don't Know How Much of the US Government Debt is Callable
Finally, the Bloomberg US Aggregate Bond Index document also tells us that the index holds callable bonds. This is a huge issue that has only risen to prominence as rates have risen and will damage the value of BND shares if rates do slowly decline, as investors currently expect that they will.
The index holds Callable Corporate and Agency bonds including mortgage bonds. Agency bonds issued since rates began to surge are almost all callable. They also pay a good 1% to 1.5% more than Treasuries of the same duration to make up for their exposure to early calls. Some can be called just a month or two after they have been issued.
I hold some Agency bonds that over the past year were bought with yields as high as 6.55%. Currently every one of them that was paying over 6% has been called as very soon after their earliest defined call date. They are being replaced by bonds paying at least 1% less. This will continue to happen if long rates drop.
I assume the same will happen with corporate bonds most of which are callable and any other kind of bond that BND holds that is callable. As a lot of bonds that have to be rolled over this year are being rolled over at much higher interest rates you can be sure that if rates start to decline those bonds will be called as soon as possible, too.
While you won't lose principal from this effect, because the fund gets the principal back from these called bonds, the loss of those high paying bonds will hit the actual distribution yield of BND as their higher yields have boosted it this year.
Since investors are counting on the higher yield of newer bonds to help them recover from the loss of value in the older bonds held by BND, the decreasing yields of the callable bond sector will make it take longer for BND holders to recover their principal.
Assume that The Fed Rate Is Never Going to Be 0.25% In Your Lifetime
Yes, the Fed will eventually, slowly, decrease its rate, but it will be much more likely to lower it only to a neutral rate somewhere near that 2% inflation target it adheres to. Lowering it more, and keeping it low too long has created asset bubbles that are now posing major headaches for the U.S. economy. The losses that people suffered when investing in BND are not going to be made up for a long time -- and that time will be even longer if intermediate rates drop back to the 2% level, which is half of what they are now.
The interest paid by BND has been eaten up by the loss suffered by the ETF's NAV and this will continue to happen unless bond rates overall decline almost as dramatically as they have risen over the past two years.
BND Is Still Not A Guaranteed Safe Buy For Those Who Invest Now
I am hearing a lot of talk that BND is a great investment for those that buy shares now because of that high SEC yield and because investors are so certain that the Federal Reserve is about to tank rates again.
But you can only believe that if you have been reading the popular financial press instead of listening to what Jerome Powell and the rest of the members of the FOMC have been stating week in and week out in their talks. Their message has been this, relentlessly: Inflation is still a factor. They are going to be very cautious in lowering rates and it is possible they will have to raise them further. They expect to see unemployment rates rise, but that is a necessary byproduct of controlling inflation and they aren't going to react unless things get very bad. Currently they are very good.
Since they met, economic data continues to point to continued inflation in the service sector, the largest sector of the U.S. economy. Rents are not dropping. Unemployment remains at historically low levels despite news of Tech layoffs. Companies have also been touting their record increases in profit margins, which should make BND holders worry because the downside of record increases in profit margins is that corporations are soaking up the benefits of cheaper oil and cheaper raw materials but charging higher prices for the products they sell -- which is the very definition of more inflation.
Inflation is tricky as us old codgers who were adults in the 1970s recall. It can look tamed and then if the reins are loosened too quickly, it runs rampant. If inflation rises another percentage point from where it is now and rates are forced up, the share price of your investment made in BND today will drop 6.4%, eating up any benefit you got from that 3.40% distribution yield.
Alternatively, if you buy a 5-year Treasury today you can lock in a state-tax free 4% yield, which is higher than BND's actual distribution yield. You will get your money back for certain the day that Treasury matures. Why lock your money up in an investment that cannot guarantee that you will get your principal back on any given date while also guaranteeing that the rate will fluctuate in ways that are impossible to predict? In short, why buy BND?
Bottom Line: Buy Individual Bonds
People are attracted to bond funds and ETFs because they are easy. But in today's environment as you have just seen, they are far from safe. It is worth the extra work involved to buy highly rated individual bonds, locking down yields until maturity and knowing you'll get your principal back if you hold to maturity. If you are investing in a tax advantaged account, FDIC insured CDs both brokered and from online banks and credit unions are also a good option.
For further details see:
BND: Why Your 'Paper Losses' Are All Too Real