There's a bond equivalent of a low-cost S&P 500 index fund

There is, and has been for a long time, a standard one-size-fits-most long-term investment: an S&P 500 index fund that tracks a broad swath of the US market.

Warren Buffett constantly recommends it. Vanguard and its founder Jack Bogle have made a business out of it, and Bogle has written books on it. Broadly, this is consensus, and those who disagree that the S&P 500 index fund is the go-to low-cost vehicle for stock investing usually pick a total stock market fund, which is basically the same thing plus a bit of small and medium-sized company stocks.

But what about bonds? What’s the one-size-fits-most fund for exposure to this asset class, also an integral part of a diversified portfolio? The answer isn’t quite as simple.

“Most people don’t know about bond indices,” said Rob Larkins, portfolio manager of T. Rowe Price’s U.S. Bond Enhanced index fund (PBDIX). Anecdotally, Larkis said, the typical retail investor doesn’t pay enough attention to bonds, and may be too heavily weighted in equities.

Why bonds can’t be ignored

For individual investors, bonds usually serve as a portfolio diversification tool, something that makes a bad stock market a little more manageable. Bonds do throw off money, providing something for investors between cash and the stock market.

“Bonds over time tend to be negatively correlated to stocks,” said Larkins. “When stocks get killed, interest rates fall, which means the value of bonds goes up. It’s an offset for a really bad period.”

For investors with long time horizons, such as young people saving for retirement, the focus shouldn’t be on bonds, because they’ll never match stocks. Older investors, who have less of an appetite for risk with shorter investment objectives, have greater use for bonds. “It’s an asset allocation question,” said Larkins. “Younger people don’t need as many bonds.”

For some people, a target date fund is the way to go, as it handles diversification to bonds automatically. Usually, the bond component is something akin to Larkins’ index fund, and that component of the portfolio grows as time goes on and goals get closer.

But for others, making one’s own diversified strategy — or a DIY target date fund — makes more sense, with lower expenses and more control. For broad bond exposure, total (U.S.) bond funds are usually considered covering the bond bases.

The S&P 500 index of the bond world

If the S&P 500 index – which comprises the 500 largest companies by market capitalization listed on the NYSE or Nasdaq – is the main benchmark for U.S. equities, the bond world’s broad benchmark is the Bloomberg Barclays U.S. Aggregate Bond Index.

“The Bloomberg Barclays U.S. Aggregate Bond Index represents investment-grade bonds that are issued by the U.S. Treasury, government agencies, mortgage-backed securities, commercial mortgage-backed securities, asset-backed securities, corporate debt, and some other government related entities,” said Larkins. “That’s the generic benchmark.”

There are a lot of bond index funds that track this, besides Larkins’ fund. Asked what its bond version of the S&P 500 index fund is, Vanguard told Yahoo Finance that it was the Vanguard Total Bond Market Index Fund (VBMFX).

Unlike the S&P 500 benchmark, which has near-unanimous appeal as a way to hold a diversified basket of equities, not everyone likes this bond benchmark. That’s because the index is weighted by the amount of bonds that are out there, which Larkins notes, isn’t always a good thing. If a company or government were to borrow a ton of money by issuing bonds, that is reflected by that debt (bonds) becoming a larger part of the index. Sometimes this is good, but it can be bad if the borrowing entity isn’t as reliable.

For example, since there is so much U.S. government debt, around two-thirds of the index is U.S. bonds. They may have a low default risk, but many consider that to be a lot of eggs in one basket and not diversified enough.

A few big differences when it comes to bond index funds

The biggest difference between an S&P 500 index fund and a broad bond index fund is that one is possible to actually own and the other isn’t. In the stock market, stocks are traded on exchanges and something is always for sale. For an S&P 500 index fund, owning a taste of everything, properly weighted is pretty darn easy (“You just buy the names at the same weight,” said Larkins). But for a bond fund, managers like Larkins have to be creative.

The aggregate U.S. bond benchmark, in comparison, has almost 10,000 securities in it and represents almost $20 trillion in assets.

“It’s really impossible to fully replicate the index. You can’t buy all 9,996 securities,” said Larkins. “IBM could have 40 different bonds. The 10-year may have $1 billion [in quantity], and if it gets bought and no one’s trading, you can’t get the bond.”

Also, bonds mature and turn over on a regular basis, meaning the index constantly evolves. With these challenges, portfolio managers just try to track the benchmark index performance, mimicking risk profiles and other characteristics.

Risk factors for a bond index are the same as for bonds and debt in general. Will a group of mortgages pay off on time? Will a corporation stay afloat to make good on its credit? Will the yield curve change shape? What will the Fed do to interest rates?

“I hate to call it active management,” said Larkins. “[But] you can’t fully replicate and there’s no such thing as pure passive. There’s going to be deviation.”

Still, despite some active behavior making sure the funds are tracking the index, costs for bond funds are competitively low, with expense ratios generally between 0.15% and 0.45%. After all, it’s still an index fund and for many investors, expenses are almost everything — especially if the goal is simply to track the bond market.

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Ethan Wolff-Mann is a writer at Yahoo Finance. Follow him on Twitter @ewolffmann. Confidential tip line: FinanceTips[at]oath[.com].

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