Why BND Is The Only Bond Fund I Own
Summary Bonds provide diversification away from stocks. Yields on bonds beat out a bank account. Rising rates are an obvious risk, but how much risk is there really? Finding a fund that’s “not too hot, not too cold”. The Vanguard Total Bond Market ETF (NYSEARCA: BND ) is the only bond fund I own, and that’s probably how it will stay. “Why own bonds at all?” some investors might be asking. I’d like to clarify why I personally have a small allocation to them, despite being relatively young at 28 years old. Markets look expensive, even after a correction While I like the valuations of the individual equities I already own, I’ll also acknowledge that the market as a whole looks expensive relative to historical valuations. According to Multpl.com , the S&P 500 is currently trading at a tick under 19 times earnings versus a historical multiple of around 15-16 times earnings. The Shiller Cyclically Adjusted PE Ratio is at around 24 times earnings, versus a historical average of around 16-17 times earnings. I think that the collapsing earnings of oil-related companies (as well as strong currency-related headwinds) could be weighing down earnings, making the market look more expensive than it really is, but I don’t think it hurts to be cautious, either. The most obvious reason I own bonds, therefore, is for diversification. Simply put, in terms of corrections and even bear markets, bonds traditionally hold up better than equities: SPY data by YCharts The majority of my individual investment portfolio and retirement accounts will remain in equities, but I do maintain a small position in the BND fund. I plan to continue to dollar cost average into it going forward, and I think it’s a better idea than holding cash while waiting for bargains to appear if markets continue to correct. Yield starvation and the lack of savings I have a tough time saving cash in excess of an emergency account right now, largely because there really isn’t any place to put it where it won’t be eaten up by inflation over time. The best place I can currently find (and where I keep my savings at) is Synchrony Bank’s high yield savings account . It only pays 1.05% APY, however, and CDs aren’t much better. Plus, with a CD, my money is locked up for a couple of years at less-than-attractive rates. So opting out of a savings account for yield, there’s short-term treasuries (NYSEARCA: SHY ) as well. These usually don’t come close to the above-mentioned savings account in yield, however, so I don’t see a reason to favor them over cash. I could also consider buying longer dated treasuries (NYSEARCA: TLT ), but then there’s substantial rate risk, as the Federal Reserve still might raise rates this year or even next year. The Fed, rates, and the “bond bubble” While I’ve often heard that there’s a bubble in bonds, and that they’re very risky due to rates being at zero for six years, I think that this talk is somewhat superficial. I’m not so sure that being 100% in equities at this point in time is for me. Long-dated treasuries offer decent yield, but they’re also very sensitive to rates. Usually to get any kind of decent yield out of a bond fund, you’d have to buy a fund with a long duration with lots of risk if rates rise. The alternative is to buy a fund with low credit quality, which pushes up yields. Either way, it seems most bond funds are either risky credit-wise or risky rising rate-wise. Here’s where The Vanguard Total Bond Market ETF starts to make sense. It yields 2.21% with an average duration of just 5.7 years. So with a 1% increase in rates, the fund would lose approximately 5.7% of its value. That’s pretty good for a bond fund in my opinion, because if the Fed does raise rates, I highly doubt it will be more than 0.25% or 0.5%. Even if it does, the yield on this fund should increase along with the bump in rates, as higher yielding bonds are added to the index. Credit wise, the BND also stands out, with the majority of the bonds held within the fund being high grade: (click to enlarge) Source: Vanguard I think that this is one of the best bond funds out there right now, especially considering its expense ratio is just 0.07%. The duration is also reasonable enough to largely prevent dramatic price drops in principal if the Fed does raise rates by the end of the year. Conclusion The BND is a “not too hot, not too cold” holding in my opinion. It’s not likely going to give investors much capital appreciation, or enough yield to get them excited about it. I’m personally holding it, however, largely because I think it’s a better alternative to cash, and I think it will hold up better than equities if the market continues to head south. I can then liquidate some (or even all) of my stake to go shopping for bargains. If markets don’t continue to correct, I don’t see that much downside, and at least I’m getting paid some income along the way. I’ll continue to be overweight equities at this point, but I don’t think it hurts to maintain a small position in the BND as an insurance measure, either.