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Over time, I’ve noticed that the percentage of U.S. government obligations in the Vanguard Total Bond Market ETF (BND) has been declining. In 2011, for example, about 71% of the portfolio was in U.S. government and government agency securities. Today it’s down to just over 59%, according to Vanguard.
So I looked at whether the largest two bond ETFs are diverging. There was once very little difference between BND and the iShares Core U.S. Aggregate Bond ETF (AGG). From the chart below, they look quite similar today, yet looks can be deceiving.
View further how BND stacks up against AGG in our ETF comparison tool.
‘Float Adjusted’ The Key
One reason the Vanguard Total Bond Fund has more holdings is the fact that, across all asset classes (mutual funds and ETFs), it’s the much larger fund, with over $288 billion in assets, or more than three times the size of the iShares fund. Otherwise, at a high level, they appear to be nearly identical.
That’s because they follow what used to be similar versions of the Bloomberg Barclays US Aggregate Bond Index.
BND follows the Bloomberg Barclays U.S. Aggregate Float Adjusted Bond Index
AGG follows the Bloomberg Barclays U.S. Aggregate Bond Index
The differences lie in the words “Float Adjusted,” and that phrase is now far more important. Float adjusted means it excludes the U.S. government securities owned by the U.S. government.
Freddy Martino, spokesperson at Vanguard, confirmed that the mortgage-backed securities (MBS) allocation has been declining for most of the past decade, because the float-adjusted benchmark excludes any MBS purchased by the Fed.
He stated that, “during the global financial crisis, the Fed purchased MBS before they even hit the open market. The Fed subsequently started to unwind QE, but then began purchasing MBS again this year.”
According to Morningstar, Vanguard’s BND now has 11 percentage points fewer AAA holdings than iShares’ AGG, and 8 percentage points more in the BBB category, the lowest of investment-grade securities. Perhaps that’s part of the reason BND performed badly when credit market liquidity dried up in March.
The annualized SEC yields of the two funds are almost identical: 1.20% for BND and 1.21% for AGG. Josh Barrickman, a Vanguard principal, senior portfolio manager and head of fixed income indexing Americas, told me the extra return Vanguard gets from taking on more BBB credit risk is offset by the fact that it owns more Treasuries, which have lower yields.
Indeed, over the past 10 years and eight months, Vanguard’s allocation to government MBS and agency securities has dropped by almost 19 percentage points, though Treasuries have increased by over 10 percentage points. But corporate has increased significantly, increasing credit risk.
Does this mean that AGG is now superior to BND? Elisabeth Kashner, VP and director of ETF research at FactSet, points out that AGG has a shorter duration (5.8 years versus 6.0). One could conclude that AGG yields an extra basis point with less credit risk and interest rate risk, from the shorter duration.
My own take is that, in spite of the shorter duration, AGG is likely to have more interest rate risk than the duration might show. Kashner recognizes that AGG's MBS increase interest-rate risk, but notes that the effect is offset by the Treasuries and corporates, to the extent that both funds' portfolio-level convexity (their rate of duration change) is currently positive.
According to FactSet, as of Aug. 31, AGG has an additional 5.1% exposure to MBS. Mortgage refinances would slow to a trickle if rates rose significantly, so the duration would increase.
So which is the better index—float or nonfloat-adjusted?
Vanguard’s Barrickman defended float-adjusted by saying that, “we believe the investable market is the right index, and we do not want to compete against the Federal Reserve buying up mortgage-backed securities to implement monetary policy.” Kashner correctly points out that, while differences between the two funds are increasing, they still have more similarities than differences.
But clearly Vanguard is taking on more credit risk over the years, and the more government debt repurchased by the U.S. government, the greater the default risk will be versus the iShares AGG. Both, however, are very high quality bond funds with low fees.
Allan Roth is the founder of Wealth Logic LLC, an hourly based financial planning firm. He is required by law to note that his columns are not meant as specific investment advice. Roth also writes for the Wall Street Journal, AARP and Financial Planning magazine. You can reach him at ar@DareToBeDull.com, or follow him on Twitter at Allan Roth (@Dull_Investing) · Twitter.