Investment grade bonds can provide stability, income, and diversification to an investment portfolio. While individual bonds may be an option for some investors, bond index funds offer a more accessible way to gain exposure to the asset class.
Bond index funds hold a portfolio of bonds that seeks to track a benchmark index, like the Bloomberg Barclays U.S. Aggregate Bond Index. This allows investors to gain broad exposure to the investment grade bond market with a single fund purchase.
Index funds also offer low costs, diversification across many bonds, and professional management. These features can make them an attractive choice, especially for new bond investors.
Below are 5 top-rated investment grade bond index funds to consider for a portfolio:
1. Vanguard Total Bond Market Index Fund (VBMFX)
With over $300 billion in total net assets, the Vanguard Total Bond Market Index Fund is one of the largest bond index funds available. It tracks the Bloomberg Barclays U.S. Aggregate Float Adjusted Index and holds over 11,000 investment grade bonds.
This provides exposure to U.S. government, corporate, mortgage-backed and asset-backed bonds with maturities ranging from 1 to 30 years. The fund’s large size contributes to extremely low expenses of just 0.05%, which is 79% less than the average bond fund fee of 0.23%.
The Vanguard Total Bond Market Index Fund has delivered consistent returns in line with the broad investment grade bond market. Its SEC 30-day yield is currently 3.7%, and the fund will pay monthly dividends throughout 2022.
While past performance does not guarantee future returns, the fund’s long track record dating back to 1986 can provide confidence for investors. Overall, its combination of low costs, broad diversification, and professional management makes this a top choice as a core bond holding.
2. iShares Core U.S. Aggregate Bond ETF (AGG)
With $88 billion in total net assets, the iShares Core U.S. Aggregate Bond ETF is one of the most popular bond index funds. It tracks the Bloomberg Barclays U.S. Aggregate Bond Index, which measures the investment grade of the U.S. dollar-denominated bond market.
Top holdings include U.S. treasuries, mortgage-backed securities, and corporate bonds. The ETF structure allows the fund to be traded intraday, unlike traditional mutual funds. Its expense ratio of just 0.04% is also among the lowest available.
The iShares Core U.S. Aggregate Bond ETF can provide a low-cost, diversified core holding for fixed income investors. It offers broad exposure to over 11,000 U.S. investment grade bonds. The fund also pays monthly dividends, with a SEC 30-day yield of 3.7% as of January 2023.
3. Vanguard Short-Term Bond Index Fund (VBIRX)
For investors who prefer shorter-term bonds, the Vanguard Short-Term Bond Index Fund is an excellent choice. It tracks the Bloomberg Barclays U.S. 1-5 Year Government/Credit Float Adjusted Index, focusing on U.S. investment grade bonds with maturities between 1 and 5 years.
The fund holds over 2,800 bonds, with top holdings in U.S. treasuries, corporate bonds, and mortgage-backed securities. The short duration positioning can help limit interest rate risk compared to longer-term bonds.
Expenses are just 0.07%, while the fund’s SEC yield is 3.5% paid monthly. The Vanguard Short-Term Bond Index Fund has delivered consistent returns in line with its benchmark index since its inception in 2009.
Overall, the fund can be a lower risk option that still provides income and diversification for fixed income investors. The short duration of positioning and extremely low costs also help make it a top choice.
READ ALSO: Should You Buy TMF Stock? A Close Look at Direxion’s 3x Long Bond ETF
4. Schwab U.S. Aggregate Bond ETF (SCHZ)
With an expense ratio of just 0.04%, the Schwab U.S. Aggregate Bond ETF is one of the cheapest bond index funds available. It tracks the Bloomberg Barclays U.S. Aggregate Bond Index, giving investors exposure to over 10,000 investment grade bonds.
Top holdings include U.S. Treasury securities, mortgage-backed securities, and corporate bonds with an intermediate average duration. The ETF structure allows trading during market hours. The fund builds a portfolio representative of the broad bond market and has closely tracked its benchmark index.
The Schwab U.S. Aggregate Bond ETF offers similar exposure to more expensive bond funds, but at a rock-bottom cost. It pays monthly dividends with a SEC 30-day yield of 3.6%. For investors looking for core bond market exposure at almost no cost, this ETF can be a great choice.
5. Fidelity Total Bond ETF (FBND)
With $21 billion in assets under management, the Fidelity Total Bond ETF provides another low-cost option for a core bond holding. It seeks to track the Bloomberg Barclays U.S. Universal Bond Index, providing exposure to U.S. investment grade bonds across treasuries, mortgage-backed securities, corporates, and more.
FBND holds over 12,500 bonds with an intermediate average duration. Expenses of just 0.04% help boost returns over time. The ETF pays dividends monthly and has a SEC 30-day yield of 3.7%. It can provide similar broad bond market exposure as more expensive active funds.
The Fidelity Total Bond ETF has closely tracked its benchmark index since its inception in 2014. It offers a straight-forward, low-cost way to build a diversified bond allocation using an ETF structure. For these reasons, it ranks among the top bond index fund options.
Choosing an Investment Grade Bond Index Fund
When choosing a bond index fund, here are a few key factors to consider:
- Index tracked – Understand the benchmark index composition to ensure it aligns with your desired bond exposure. Broad-based indexes can provide core diversification. More targeted indexes, like for short-term bonds, allow you to hone in on specific segments.
- Fund size – Bigger is often better for index funds. Large assets under management can lead to improved liquidity and even lower expenses.
- Expenses – Index funds should charge low fees, so compare expenses carefully. Even small differences in fees compound over time.
- Tracking error – Index funds aim to closely track their benchmark index, not outperform. Compare historical returns to see how closely the fund tracks its index. A lower tracking error is better.
- ETF vs. mutual fund – ETFs trade intraday like stocks, but mutual fund trades only execute once per day after market closes. ETFs may have higher trading costs, while mutual funds have possible minimum investment amounts.
Building a Bond Allocation with Index Funds
Index funds can provide the foundation for building a diversified bond allocation. Here are a few tips on incorporating them into your portfolio:
- Start with core holdings – Broad-based funds like a total bond market or aggregate bond index fund can provide a low-cost core. More targeted funds can be used to tilt the allocation if desired.
- Rebalance periodically – Revisiting your allocation every 6-12 months and rebalancing back to target levels helps maintain your intended exposures.
- Consider fund placements – Bond index funds are well-suited for retirement accounts like 401(k)s or IRAs where you can buy and hold them for the long term. Taxable Accounts may be better suited to municipal bond index funds, which provide tax-exempt income.
- Focus on costs – Index funds simplify bond investing, so you can focus on minimizing costs with low expense ratios. Expenses directly reduce investment returns.
- Maintain diversification – Diversification across bond sectors, issuers, and maturities helps manage portfolio risk. Index funds provide cheap, instant diversification.
To Recap
Bond index funds offer a straightforward way to build diversified income and stability into your investment portfolio. They provide instant exposure to hundreds or thousands of investment grade bonds in a single fund.
Low costs, daily liquidity, tax efficiency, and professional management make index funds an attractive option compared to individual bonds or actively managed bond funds for many investors.
The top bond index funds highlighted in this article can serve as core portfolio holdings to achieve your desired asset allocation. Pairing these funds with stock index funds can provide a balanced, diversified, and low-cost portfolio.
Revisiting your target asset allocation periodically and rebalancing helps maintain your intended exposures over time. With their simplicity and transparency, bond index funds allow you to focus on managing costs and diversification, so you keep more of your returns.
READ ALSO: Best Gold ETFs to Buy in 2024: Top Options for Investing in Gold
Bond Index Funds FAQs
What is a bond index fund?
A bond index fund is a type of mutual fund or ETF that invests in a portfolio of bonds seeking to replicate the performance of a benchmark bond index. They provide broad diversification across many bonds in a single fund.
How are they different from individual bonds?
Individual bonds are a single security with unique risks based on that one issuer. Index funds hold hundreds or thousands of bonds to eliminate single issuer risk. They also offer low costs, daily liquidity, and no minimum investment amounts that can be barriers to purchasing individual bonds.
What are the benefits of bond index funds?
Benefits include instant diversification, lower costs than active funds, tax efficiency in retirement accounts, daily liquidity for trading (in ETFs), professional management, and transparency into holdings.
What should I look for when choosing a bond index fund?
Look for a low expense ratio, sufficient fund size and assets under management, closely tracking its index, investment grade credit quality, and an index that aligns with your desired exposures. Broad-based indexes can provide core diversification.
How much of my portfolio should I put in bond index funds?
Asset allocation depends on your risk tolerance, time horizon, financial goals, and more. A common starting point is allocating your age to bonds, so a 40 year old would allocate 40% to bonds. Conservative investors may allocate more, while aggressive investors can allocate less. Bond index funds can provide fixed income exposure in a diversified portfolio.
What risks do bond index funds carry?
Bond index funds have interest rate risk, credit risk, inflation risk, early redemption risk, and risks associated with any tracking error between the fund and index. The diversified nature helps manage risks. Overall, index funds carry lower risk than individual bonds.
How are bond index funds taxed?
Bond index funds typically distribute dividends that are taxed at ordinary income rates. Capital gains distributions may occur when bonds are sold and taxed at long-term capital gains rates. ETFs tend to be more tax-efficient than mutual funds due to their creation/redemption processes. Bond index funds work well in tax-advantaged accounts.
Do index funds pay monthly dividends?
Most bond index funds pay monthly dividends that can provide income for investors. Dividend payments reflect the interest payments generated by the underlying portfolio of bonds held in the fund.
In another related article, The Best Stock Brokers for Day Trading in 2024
