By John C. Bogle
In 1986, the first decade of Vanguard’s stock index fund came to a close. Its performance success and its growing, if modest, acceptance led to an obvious idea: If indexing worked so well in the stock market, why wouldn’t it also work in the bond market? So as 1986 came to a close, we took our second plunge into index waters. Vanguard formed the first bond index fund for individual investors. Because most bond funds were grossly overpriced, often carrying both high expenses and excessive sales charges, there was no question in my mind that bond index funds would come to meet a major need in the marketplace. A low-cost, no-load index fund seemed certain to fill much of that need.
With the formation of Vanguard Bond Market Fund, Vanguard was again the pioneer. We had been laying the groundwork for a bond index fund during much of 1986, but the final inspiration—this is true!—came when Forbes magazine, writing about the second-rate returns and high costs of most fixed income mutual funds, expressed the crying need for a low-cost bond index fund.
A Second Cri de Coeur
The magazine plaintively asked, “Vanguard, where are you when we need you?” Thus, yet another cri de coeur—an echo of the plea of Nobel laureate Paul Samuelson a decade earlier for a stock index fund—provided the final impetus. Once again, we responded. In the ensuing years, our bond index fund would again prove to be both an artistic and a commercial success. Vanguard Total Bond Market Index Fund admirably tracked the returns in the Lehman Brothers Bond Index of U.S. investment grade bonds (now called Barclays U.S. Aggregate Bond Index.) By the end of its first decade, the fund had become one of the industry’s 10 largest bond mutual funds.
While it has taken time, the Fund has now emerged as the second-largest bond fund in the industry. As 2012 began, the assets of its two linked portfolios totaled $160 billion, second only to PIMCO’s Total Return Bond Fund, up in the stratosphere with $250 billion of assets, thanks to the superior returns it has earned under the direction of fixed-income industry legend Bill Gross. But no other bond fund even approaches those levels. Together, the next 10 largest funds hold assets averaging but $34 billion.
That dominant size reflects the fact that the Vanguard Total Bond Market Index Fund has fully measured up to its performance potential. It’s now 25-year lifetime rate of annual return averaged 6.9 percent, a nice margin of 1.2 percentage points over the average 5.7 percent rate of return of its taxable peers. That superiority comes despite the Fund’s assuming far less credit risk, for the fund (and the bond market index itself) typically hold more than 70 percent of assets in securities backed by the U.S. Treasury and its agencies, including mortgage pass-through certificates. Compounded, the appreciation of a $10,000 investment made at the close of 1986 was remarkable: average actively-managed bond fund $29,900; Vanguard’s passively-managed bond index fund, $42,600—an enhancement in profit of more than 40 percent. This stunning advantage once again reaffirms the timeless truism: Never forget either the magic of long-term compounding of returns, nor the tyranny of long-term compounding of costs.
Learning from Experience
Certainly the marketplace of bond investors has learned from that truism. Bond index funds as a group now claim a record high 17 percent market share among taxable bond funds—$370 billion of the $2.4 trillion total. What’s more, during 2011, bond index funds accounted for fully 40 percent of the investor cash flow into taxable fixed-income funds as a group. This penetration is a harbinger that the trend toward bond indexing will continue to strengthen, just as has the trend toward stock indexing. This accelerating trend confirms what Peter Fisher, talented head of the fixed-income group for giant global money manager BlackRock, has observed: “We’re moving to the second phase of the index revolution. The world is a frightening, uncertain place, and investors want to make their (bond) portfolios much simpler so they can sleep at night.”
With an annual expense ratio now averaging 0.10 percent (10 basis points), Vanguard Total Bond Market Index Fund remains a ferocious competitor. Peer bond index funds are charging an average of 0.40 percent (40 basis points). Peer actively-managed taxable bond funds are charging an average of 1.05 percent (105 basis points). It is hard to imagine that the superiority of the bond indexing strategy will not continue to prove itself over the long term.
CAVEAT: If there is a weakness to the case for the all-bond-market-index funds, it is that Barclay’s Aggregate Bond Index itself is so heavily weighted by U.S. Treasury and agency securities and federally backed mortgage bonds (GNMAs). In 1986, in the first annual report of the Vanguard’s bond index, I noted that U.S.-government-backed bonds accounted for 77 percent of assets. In the Fund’s most recent annual report, it was only slightly lower, at 72 percent. With Treasury yields recently near their lowest levels since the 1940s—just 1.6 percent for the 10-year Treasury note—the risk of rising rates cannot be ignored.
So it’s time to create yet another bond index fund, a Total Corporate Bond Index Fund. Its estimated yield in September 2012 is 3.0 percent, versus 1.7 percent for the Total Bond Market Index Fund. A corporate bond index fund would be useful to investors who require higher income without assuming undue risk. An investor who transferred, say, half of his bond holdings in the total bond index portfolio into an investment-grade corporate bond portfolio would still have a 35 percent position in U.S. government securities. As low interest rates continue for the foreseeable future, and spreads between corporates and Treasurys remain at current levels, it can only be a matter of time until a total corporate bond index fund is made available to investors.