The Best Bond Index Funds: Part 2

The Indexing Trend

Once confined to stocks, index investing is now prevalent with bonds. Their influence extends past the mainstream categories. In recent years, indexing has come to dominate the less common bond sectors, which historically were almost entirely actively managed.

The following chart tells the tale. It shows the aggregate net sales from 2021 through 2023 for the four fixed-income fund sectors discussed in this article: 1) high yield, 2) inflation-protected, 3) municipal, and 4) global. The pattern is clear. While active funds have not been universally shunned—in some years, with some groups, the inflows have been positive—they are quickly losing favor. The future lies elsewhere.

The Format

This column’s process will mirror those of its predecessors, which covered US stocks, international stocks, and mainstream US bonds. Within each category, I screen for widely available mutual funds or exchange-traded funds—no institutional funds, nor funds that are only available through 401(k) plans—that had five-year track records as of December 2023. I then select the cheapest indexed offerings, listing them in order of their expense ratios.

Of course, while cost is of primary importance with indexed investments, it is not the only consideration. The benchmarks used by each fund differ, sometimes significantly. The article cannot dissect those differences, but it does provide each fund’s benchmark for those who wish to investigate further. It also shows the funds’ five-year returns (through Dec. 31, 2023), current SEC yields, and portfolio durations. The latter indicates the degree of the funds’ interest-rate sensitivity.

High Yield

High-yield index funds fall neatly into two groups. The first three funds on the list, from SPDR, Xtrackers, and iShares, replicate the complete domestic high-yield market. Roughly speaking, they invest about 90% of their assets in bonds with BB and single-B credit ratings. The final two funds own only “fallen angels”—bonds that were once investment-grade but which have since stumbled. They have higher overall credit ratings, holding two thirds of their portfolios in BB securities, and meaningfully longer durations.

Fallen-angel funds have lower SEC yields than do other high-yield index funds, as befits their somewhat stronger credit quality. They also have posted better five-year returns. However, the latter owes entirely to the first three years of the period, as fallen-angel funds have since trailed their competitors. Despite being slightly more creditworthy, they can at times be riskier owing to their greater interest-rate sensitivity. Such proved the case in 2022.

Finally, it should be mentioned that the list omits the cheapest high-yield fund of all, Schwab High Yield Bond ETF SCYB, as it launched last summer. It costs a mere 0.03% annually and is no doubt an excellent investment.

Inflation-Protected

Inflation-protected bond funds are currently unpopular. The reason is straightforward: When inflation surged in 2022, “inflation-protected” bonds fell as far as their conventional rivals, which understandably distressed their owners. If these securities implode the moment that inflation arrives, what good are they?

The answer to why Treasury Inflation-Protected Securities behaved so badly two years ago is a long story. The short version is that if inflation-protected bonds are priced attractively, which was not the case entering 2022, they should hedge effectively against inflation. Today, inflation-protected bonds are cheaper than at almost any time over the past 15 years. Their prices suggest that fund shareholders should be buying them, not selling.

Happily, there are several fine choices among inflation-protected bond funds, all of which boast pleasantly modest expense ratios. One note with the table, though: The SEC yields for inflation-protected funds are goofy. I have no idea why Vanguard Short-Term Inflation-Protected Securities ETF VTIP has a yield that’s more than 1 percentage point above the otherwise similar iShares 0-5 Year TIPS Bond ETF STIP. As for the zany 9.50% figure for Schwab Inflation-Protected Index SWRSX, don’t blame Morningstar’s data. That number comes straight from Schwab SCHW itself.

Municipal

I treated this section differently. There are four national municipal-bond categories: long, intermediate, short, and high-yield. For each group, I selected the cheapest fund. Due to expense-ratio ties, two listings appear for intermediate and short funds.

As the evidence suggests, indexing arrived late to municipal bonds. There are several appealing choices among intermediate and short funds, but after that, the pickings become slim. That will no doubt change over the next few years. Also, it should be noted, Schwab once again offers a low-cost fund that is too new to qualify. Schwab Municipal Bond ETF SCMB charges a mere 0.03% per year and will likely top the muni-national intermediate chart after it celebrates its fifth birthday.

Global (Hedged)

Global-bond funds come in two forms, 1) hedged into US dollars and 2) unhedged. Although the latter are theoretically more attractive, as their foreign-currency exposure provides additional diversification, hedged funds are more popular with investors. That is not surprising, as they have not only been less volatile, but have posted superior five-, 10-, and 15-year returns, thanks to the dollar’s strength.

There aren’t many global hedged options, but the ones that do exist are attractive. It’s hard for this old-timer to believe that fund companies can invest around the world while applying a currency-hedging strategy for between 0.05% and 0.11% per year. There was a time, not so long ago, when expense ratios 5 times higher for that service would have been considered bargains.

One final note: As suggested by the benchmark names, Vanguard Total World Bond ETF BNDW includes US securities, while the other three funds do not. Morningstar could, of course, create a new and separate fixed-income category to distinguish between global hedged funds that hold US bonds and those that do not ... but enough is enough. The company provides 129 fund categories as it is.