Vanguard is Wrong About International Bonds

Anyone who has talked to me about investing knows that I am a big fan of Vanguard. My wife and I have all our accounts with Vanguard; all our children, including our three week old, have Vanguard accounts; and every member of our family has a Vanguard hat. Vanguard is the first, and, in most cases the only investment company I recommend. They are the pioneers of low cost index funds and they still do it as well or better than anyone else. Anyone who talks to me about investing also knows that I believe investing should be as simple as possible. Which is why I’m attracted to Vanguard Target Retirement funds and LifeStrategy Funds. 

Target Retirement Funds are a common offering in many 401k plans. They offer a single fund with a diversified asset mix which automatically adjusts to become more conservative as an investor approaches retirement. An investor simply chooses the Target Retirement Fund closest to their planned retirement year and focuses on saving as much as they reasonably can. LifeStrategy funds offer a similar diversified asset mix, but the allocation remains the same instead of adjusting with time. Both funds are attractive options for investors who lack the time or interest to manage their own investments, but do not want the hassle or expense of an investment adviser. However, as with all things investing, it is important to understand the asset mix within the fund and make sure that it actually makes sense.

I am not going to, in this post, address the rate or time at which the Target Retirement Funds become more conservative, referred to as the fund’s “glidepath.” That is an important consideration, but an easy one to adjust as one can simply select a fund designed for either older or younger investors. I’m going to focus on the asset allocation of the funds at any given time. Both the Target Retirement Funds and the LifeStrategy Funds hold a mix of stocks and bonds. As of the time of my writing they invest 60% of their stocks in the Total US Stock Market, and 40% of their stocks in the Total International Stock Market. They invest 70% of their fixed income allocation in US bonds, and 30% in international bonds. 

Predicting the future return of various asset classes has more in common with magic than science, but we can break future return into component parts and analyze them separately. For bonds there are three components: current yield, defaults, and changes in interest rates. The current yield is exactly what your return will be if no one defaults and interest rates do not change. Defaults lower your return, but default risk can be effectively managed by investing only in high quality bonds, which Vanguard does in its LifeStrategy and Target Retirement Funds. Changes in interest rate are the most unpredictable element of future bond returns. If interest rates fall your bond investment will gain value in the short term as its income becomes more attractive, but lose value in the long term as the interest and principal is reinvested at lower rates of return. If interest rates rise your bonds will lose value in the short term as their income becomes less attractive, but your interest and principal will be reinvested at higher rates of return earning you more in the long run.

The current yield to maturity of Vanguard’s International Bond Fund is 0.4%. With no changes in interest rates and zero defaults an investor in that fund will earn 40 basis points a year forever. If interest rates increase her returns over the short term will be even lower, and if they fall her returns over the long term will be even lower. So why is Vanguard including this asset in their all-in-one funds? How much lower can interest rates really go? Betting that they will go lower is short term speculation, inappropriate for long term investors; betting that they will go higher means an investor should avoid investing until they do. 

I wouldn’t be writing this if there weren’t better options. If 40 basis points was the best an investor could do in fixed income I would tighten my belt and not complain, but Vanguard does have better options. As I write this the yield to maturity for Vanguard’s Total US Bond Market Fund (VBTLX) is 1.7%. That’s over 4 times the yield of international bonds. An investor with $500k in a Target Retirement Fund that invests 12% in international bonds is losing $780/year in yield. Vanguard should move the entirety of its bond positions inside Target Retirement and LifeStrategy Funds to US bonds until the yield of the international bond market becomes more competitive.

Obviously, it is unlikely that Vanguard is going to listen to me, although if enough people complain it may listen to all of us. So what should you personally do? First you need to assess the cost. If you are relatively young and relatively aggressive the allocation to international bonds inside your target date fund is insignificant. Vanguard’s Target Retirement Fund with the longest time horizon, Target Retirement 2065, currently has 3.2% of its assets allocated to international bonds, costing investors in that fund 4 basis points a year in yield. $4 a year for every $10,000 is not worth doing anything about unless your account balance is quite high. 

Second, consider other options. Fidelity and Charles Schwabb both have index based target retirement funds that do not contain international bonds, if one of those is an option for you it is worth considering, but be careful with these companies. They both also have higher fee actively managed Target Retirement Funds. 

Third, do it yourself or with help from an adviser. Although it is not worth the hassle for $4 per year, once an investor is losing $100+ per year it may make sense to build one’s own portfolio or get help from a low cost fee only investment adviser. Investors who want to know how much their current asset allocation is costing them should contact me to discuss a third party portfolio review.

-Joe Bailey

Disclosure. I invest in Vanguard Index funds personally and recommend them to clients. All investments involve risk including the possible loss of the principal invested. Past results are a remarkably poor indicator of future returns. Joe Bailey is a Registered Investment Adviser and charges $75 for third party portfolio reviews.