What are the best bond funds to buy now? This is a simple question that is often unnecessarily complicated by investors. The best bond funds to buy now are the same bond funds you should have bought yesterday and the same bond funds you should buy tomorrow.
But isn’t past performance a poor predictor of future results? Indeed it is, but the best bond funds are not those that earned the highest return in any given year.
The best bond funds are the cheapest bond funds. Cost is one of the most reliable predictors of mutual fund performance.
Who offers the cheapest bond funds? For my money and our clients’ money, the answer has always been Vanguard. Vanguard bond funds are most often the cheapest bond funds on the market.
You might find a bond ETF that has a lower expense ratio than a comparable Vanguard mutual fund, but with ETFs, the expense ratio is only one component of the cost. Investors in bond ETFs must also take into account the cost of bid-ask spreads that open-end mutual fund investors don’t pay and more importantly the possibility that you may buy or sell a bond ETF above or below the fund’s net asset value. If you buy a bond ETF when it is in high demand and sell when nobody wants to touch it, you could easily give up two percentage points in return. With yields in the low single digits across the bond market, a 2% haircut might eat up all of your return.
The cost advantage of Vanguard Bond Funds is shockingly large. In the table below I show the expense ratio for the admiral shares of three of Vanguard’s bond funds compared to the Morningstar category average.
Vanguard admiral shares are a lower cost class of mutual fund shares than Vanguard’s Investor shares. To qualify for admiral status you must have $50,000 invested in the fund. If you don’t have the $50,000 to invest in admiral shares you’ll have to buy the investor class shares which will cost you, on average about 0.10% more—still among the cheapest bond funds on the market.
|Fund||Expense Ratio||Category Avg.|
|Vanguard GNMA Admiral Shares||0.11%||0.92%|
|Vanguard Intermediate-term Investment Grade||0.10%||0.77%|
|Vanguard Short-term Investment Grade||0.10%||0.76%|
An investment in the Vanguard GNMA fund compared to the category average will save you 0.81% per year. The yield on the Merrill Lynch GNMA index, which of course doesn’t pay an expense ratio, is 2.82%. So the average GNMA fund eats up about one-third of your annual yield while the Vanguard GNMA fund only takes about 4%.
That is a high hurdle for the average GNMA bond fund to overcome.
For the best bond fund buys today and tomorrow, stick with Vanguard.
Jeremy Jones, CFA
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