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Bogleheads on Investing with Nick Gendron and Josh Barrickman – Episode 45

Post on: April 14, 2022 by Rick Ferri

On our May “Bogleheads on Investing” podcast, we’ll have two guests who will talk about total bond market investing. 

The first guest is Nick Gendron, Global Head of Fixed Income Index Product Management at Bloomberg. This is where the index originates, and Nick is the total bond market guru. The second guest is Josh Barrickman, Principal, Senior Portfolio Manager, and Head of Fixed Income Indexing Americas. He and his team manage Vanguard bond index fund portfolios invested in U.S. and international markets.

In this podcast we cover history, composition, changes in the indices over time, variations of the total bond market index, and how a portfolio manager goes about investing their total bond market index fund when not all bonds are liquid.

Listen On

Rick Ferri: Welcome everyone to Bogleheads on Investing episode number 45. Today our discussion is on the total bond market index fund and we have two special guests, Nick Gendron, Global Head of Fixed Income Index Product Development at Bloomberg, and Josh Barrickman, Principal and Head of Fixed Income Index Investing at Vanguard.

Hi everyone, my name is Rick Ferri, and I’m host of Bogleheads on Investing. This episode, as with all episodes, is brought to you by the John C. Bogle Center for Financial Literacy, a 501(c)(3) non-profit organization that you can find at boglecenter.net.

And before we get started with this episode I have a public announcement. Tickets for the Bogleheads Conference have gone on sale. You can find information on boglecenter.net and bogleheads.org. The conference will take place in a suburb of Chicago on October 12 through the 14th. It is a non-commercial conference. There are no sponsors. There is no commercialism. No one is going to try and sell you anything. It’s pure investment education. I’m looking forward to seeing you there.

In this 45th episode of Bogleheads on Investing we’re discussing total bond market investing, also called aggregate bond market investing. And I have two special guests. My first guest is Nick Gendron. He is the Global Head of Fixed Income Index Product Management at Bloomberg. Nick’s team creates the Bloomberg Aggregate Bond Market Index, which is the index that total bond market index funds follow.

The next guest is Josh Barrickman. He is Principal, and head of Fixed Income Indexing at Vanguard. Josh’s team are portfolio managers. They take the index that Bloomberg puts together and they have to create a real live working portfolio out of it, and that’s quite a challenge.

We’re going to start first with Nick and then we’re going to move on to Josh. So with no further ado, let me introduce Nick Gendron. Welcome to Bogleheads on Investing Podcast, Nick.

Nick Gendron: Thank you very much Rick. Appreciate it, and really happy to be here with you.

Rick Ferri: Well, thanks. You are the first guest on our podcast today and your job is to create the fixed income indexes that are used for index fund tracking. Before we get moving here and talking about total market or aggregate bond market index which is going to be our main focus today, tell us a little bit about your background and how you got to be the head of fixed income index product management for Bloomberg

Nick Gendron: Yeah, sure. I’m happy to share that. I actually joined Lehman Brothers a few years after I got out of college. I was going for my MBA back then and they were looking for people to come in and help them as they were starting to really build an index business. Just come in and help with client support around indexes. They were starting to get a lot of questions around what we were doing and Lehman Brothers was certainly a big bond shop so it made sense that they were producing these types of indices to share with the marketplace.

But I really came in more of a client support role. Didn’t know much about bonds at the time, but was looking for a change of career and they gave that to me, and you know the rest was history. I just kind of kept moving through the system. We did a lot of portfolio strategy work for clients with our indices etc. and we learned all sorts of risk analytics and provided those to the marketplace as well, and ultimately evolved into Barclays once Lehman went under in 2008. And then Bloomberg bought our franchise from Barclays in August of 2016. So I’ve been at Bloomberg for about the last five and one half years.

Rick Ferri: So if I held that up, you’ve been involved in fixed income indexing for thirty years as of next month. Is that correct?

Nick Gendron: That is correct. We’re coming right up on the 30-year anniversary which is really hard to believe. But it’s definitely been an exciting run and it’s kept me in the business because the business just keeps changing and the needs of investors keep changing and it’s definitely not a rinse and repeat type industry. There’s always innovation needed and lots of interesting client conversations to have.

Rick Ferri: Now originally when you went to Lehman Brothers the number of index funds out there were fairly limited. So the purpose of the indices that you were running were more for benchmarking. So could you describe the difference between indexes for a benchmark versus index for an investable product

Nick Gendron: Many clients use our indices for what we call just benchmarking and for just standard benchmarking clients they really need a home base or foundation to which, from which, to make investment decisions. If they use the US Aggregate for instance, as a benchmark, that is what is considered market neutral, so for them to prove that they can use their investment prowess, if you will, to add value, that’s a great place to compare yourself to.

If the US Aggregate is truly meant to be a market neutral representation of the universe we do have many clients use that just to compare to and manage their risk to that benchmark each day while hopefully showing outperformance.

From a passive side of things, certainly most ETFs, if you will, and many mutual funds, and many institutional funds really try to track the index exactly, by the basis point almost, in fixed income so it really is a difference between passive versus active

Rick Ferri: It’s interesting that a lot of the index fund managers use the term “Total Bond Market” for the US Aggregate Bond Market Index and Barclay’s does not use that term, “Total Bond Market” because it’s not the total bond market, so could you explain what is the US Aggregate bond market.

Nick Gendron: Yeah. I mean in some ways, Rick, it’s intended to be the total of some bond market but the question is what bond market is it supposed to be. In the case of the US Aggregate it’s really designed to be the representation of what I would call the core investment grade US dollar denominated.

So if you’re in the US, any US dollar bond. But again the key thing is core, investment grade US dollar denominated, and then we have to give it a name, right? And US Aggregate has been sort of the trademark name for a long time and it’s become a flagship name in the industry.

Yeah, and we could have at some point of time way back when decided, hey we’re going to call this the total bond market indexbut we decided nope, the US Aggregate is a better name. And again, total bond market to me would be every bond out there. You know, it could be any asset class. It could be any currency denomination, etc. So again, it really depends on the market you are talking about.

Rick Ferri: Yeah, it’s interesting because it really… there’s a lot of types of bonds, US bonds, that are not in the US Aggregate Index which is the basis for the total bond market index funds. The one that jumps out is TIPS, Treasury Inflation Protected Securities. Gosh, I mean this seems to be such a natural fit for a total bond market index fund but it’s not in the aggregate index, so why don’t you start with that and kind of go down the list.

Nick Gendron: You prompted a very interesting dynamic when TIPs were started to be issued in 1997. And the reason I remember that exact date is just because that was the birth, if you will, of what we call our Index Advisory Councils, which became more formal meetings with our major index users to get feedback on how we evolved the methodology within our indices.

But TIPS was a huge debate back then. Our inclination when TIPs were issued was to put them in the US Aggregate. There were many investors that disagreed with that sentiment, that inflation itself really should be a separate asset class and doesn’t belong in the true spirit of a traditional fixed income investment. So there was a debate and if you went around the industry today you’d still probably get several investors who would think that TIPs should be part of the US Aggregate.

That’s some of the interesting part of being an index provider--is investors don’t always agree on everything. The bond market has a lot of different factors,a lot of different types of securities that are out there, and we have to work to try to synthesize all of that feedback, if you will, into what we feel should be in the US Aggregate

So that there was actually a real good debate and it’s something that we’ve brought up over the years with our index councils. 1997 wasn’t the only time, but still as of today, TIPS are not part of the benchmark.

Rick Ferri: And this is an investment grade index so there’s no high-yield.

Nick Gendron: No high-yield-- completely separate High-Yield Index--and the definition of Aggegate for us is investment grade is one of the keys.

You know, we have what’s called a Global Aggregate too, which spans 28 currencies, but it’s all investment grade. So again, separate indices for high-yield, for Emerging Markets, municipals, inflation, etc.

The Aggregate part of it, the investment grade part of the bond market, is by far the largest component.

Rick Ferri: And ironically something that is in the index which a lot of people don’t know are what are called Yankee bonds which are foreign bonds.

Nick Gendron: Yep, Yankee bonds are an interesting dynamic. There are a lot of non-US institutions or government bodies, what have you, that issue US dollar denominated securities.

So just a little research on this, there’s actually in the US Aggregate, there’s 1400 securities that are Yankee bonds. Almost two trillion of the index is in Yankee bonds. So you say, “Okay, well who are those issuers?”

Many of them are these supranational institutions. IBRD [International Bank for Reconstruction and Development], EIB [European Investment Bank], ADB [Asia Development Bank]. So there’s these supranationals that issue a lot of debt and most of it is in US dollars. So those go in the US Aggregate. They’re investment grade debt. Yes, but they’re non-governments.

Like Mexico, Peru, Philippines all issue investment grade debt in US dollars that’s in the US Aggregate. It’s an interesting component of the market. Canadian provinces issue US dollar denominated debt so those are some examples of Yankee bonds.

There’s certainly other government bodies that issue US dollar denominated bonds as well that are what are called 144A’s, or they’re not SEC registered bonds, and that’s another rule of the US Aggregate. They have to be SEC registered. So Saudi or Indonesia, they issue US dollar denominated debt as well, but it is in 144A form so that does not go into the US Aggregate Index. These are just some of the rules that have been in place for a while. And we revisit them every so often but that’s how we stand today.

Rick Ferri: What would you say is the percentage of the US Aggregate Index is in Yankee bonds?

Nick Gendron: So I guess it’s just a matter of the math. Pretty easy to figure out if the US Aggregate is 25 trillion in size and Yankees are two trillion of that

Rick Ferri: About 8 per cent almost. And you know it’s funny because a lot of people say, ”Oh we need to invest in the US bond market and we need to invest in foreign bonds,” and I tell people, “Well, I mean the US total bond market index funds already have this eight percent already in foreign bonds and they’re shocked at that. Let me ask about US STRIPS, zero coupons

In the US Aggregate Index one of the rules is that it has to be a fixed-rate coupon. It can’t be a variable rate coupon, it has to be fixed rate. Do you consider zero coupon bonds to be fixed-rate bonds?

Nick Gendron: That’s a good question. My answer to that would be yes as long as they’re originally issued as zero coupons. So US Treasuries are stripped from normal bonds so we include the normal bonds in the index. We don’t want to create sort of stripped out versions of those bonds or something that would cause us to double count those securities. So we just take the outstanding amount of the originally issued security and that’s what goes into the index.

Rick Ferri: Let’s talk about mortgages because you get the pure mortgage and you’ve got collateralized mortgage obligations, packaged mortgages if you roll tranches and so forth so would be double counting if you had both of these in, so which one do you count?

Nick Gendron: It’s just the straight mortgage pools that are issued. We don’t have CMOs [Collateralized Mortgage Obligations] in the index. But what we do is we take all the residential mortgages as issued as pools, and then aggregate those into the index. And as of today there’s about, I think it’s about 25 -26 percent of the index is in mortgages.

Rick Ferri: And these mortgages are government- backed only?

Nick Gendron: Yeah, or agency-backed. So they’re backed by the three agencies: Ginnie Mae, Freddie Mac, and Fannie Mae. You know, we’re tracking 30-year issuance, 15-year issuance, 20-year issuance. Really where the market is most concentrated. And certainly there’s – again, this is where the bulk of the mortgage market is today and over time – as of today, again in what we call our US Aggregate or sort of the core universe, it’s only those residential mortgages backed by those agencies.

Rick Ferri: So you’ve been around for 30 years now in this bond indexing business and you have seen something like the US Aggregate Index shift. Not only does shift in composition as more mortgages versus corporates or treasuries are created, the sectors get bigger and smaller and how has the index shifting, how has it shifted, and how is it shifting?

Nick Gendron: Yeah. Again Rick, what we’re doing every month basically, just a quick background, every month we have a set of rules for what bonds go into the index and which don’t. And every month it’s a monthly rebalancing. Every month we go out, we capture that meet the rules, we rebalance the index. So you know it’s very unique. It’s very different from stock indexing, right? We are– there’s bonds being issued all the time so we want to keep current with what the market looks like and that’s similar to other, how other competitor indices do it as well. Monthly rebalancing is fairly standard in the industry.

But what that does is it incorporates and continues to show as issuance patterns differ and as mortgages pay down and as corporations come in and out of the market to issue bonds. What our index is doing is just reflecting the updated reality of the situation.

So a good example. How have the sectors changed over the years? Well if I look at US Treasuries, for instance, today US Treasuries are about 39 percent of the overall index but they’ve been as low as 22 percent down in 2002. They’ve been as high as almost 50 percent in 1985. They’re sort of at one of the higher points that they’ve been in a little while but it just is totally fluctuated basically on how the US Treasury is deciding to issue debt and in what maturities and in what size, right? And we just reflect that reality as the market just sort of evolves and that whole evolution takes place--so it’s kind of an interesting part of it--you don’t really see it month to month but if you look at it over long periods of time you’ll see the trends.

Rick Ferri: And the interesting, in the bond market which is different than the stock market, is that the stock market is set by buyers and sellers, so the stocks you like, like Google and Apple, the more buyers, the price of the stock goes up. It becomes a greater percentage of the index because of demand, if you will, from marketplace buying, buying more stock and pushing the valuations of these up. But that’s not really what happens in the bond market. In the bond market it’s how much the issuers issue that determine the sector allocation so it is quite different.

Nick Gendron: It’s market value weighted so price, you know the market price of a bond as it goes up it will contribute a bit more but it’s really the main bulk of the percent weight of that bond is going to be how much it has issued in debt. You know we are market-value weighting each bond in the index so price does factor in, but again, as you said, it’s the amount outstanding of the bond times the price, and there’s a crude value in there too for a market value but which sets the weight of a bond in the index.

Rick Ferri: So this year, 2022, we’ve seen interest rates move higher and the value of fixed income across the board has moved down because of that and this function is called duration. So we can measure how much it’s going to move down, the prices move down based on how much interest rates move up, can you, number one speak about duration and then talk about how duration changes?

If interest rates are very low there’s higher duration when interest rates are very low and there’s lower duration when interest rates are very high. Could you explain the whole concept of duration, how it moves?

Nick Gendron: Sure. With the US Aggregate it’s interesting because government and credit, or corporate portions of it are what you call positively convex bonds but the mortgage piece of it reacts, actually the complete opposite way. So I’ll go through that dynamic but the duration of the index definitely fluctuates with the interest rate environment. It tends to be because the US Aggregate is about a third in mortgages. It’s a little less than that, probably a quarter mortgages now, but over the course of time it’s been about a third.

When rates move in a certain direction mortgages are very, very volatile with respect to their durations because if you get into higher interest rate environments like today even though we’re not at that peak points, the mortgage duration is completely dependent on what type of pre-payments are expected in the marketplace because they’re all callable securities. If rates go low, obviously everybody’s going to pay down their mortgages and try to lock in a lower rate and therefore the existing mortgages in the index are all going to pay down and new ones are going to be issued, and so that duration can get quite low in low interest environments. In higher interest environments, as we’ve moved up recently, the duration of the mortgage sector about in the fives right now, 5.5 if I’m not mistaken, it got as low as less than a year back in 2008 at the financial crisis when their rates were really dropping and homeowners were finding money very cheap and refinancing etc,

Rick Ferri:So you were basically saying that when the duration was less than a year that was just a big huge turnover in the mortgage market. People were refinancing. And now that interest rates have moved up a lot less as that is going on, so people are holding on to their mortgages and makes the maturity, if you will, of the bond, much further out.

Nick Gendron: Much further out, much more exposed to interest rate risk, right? And duration, as you mentioned, is really how prices are going to respond to interest rate moves. So it’s all interest rate risk, that’s the main risk that almost every fixed income investor is worried about is: what’s the duration of the index, what’s the duration of my portfolio. If you’re mismatched there, and everybody knows it’s tough to time duration or tough to time interest rates, you can, you could really get on the right side of that and do very well. But if you’re on the wrong side of it it’s going to be your main reason why you’ve underperformed in fixed income.

So if we look at the duration, of how it’s drifted over time--you know the US Aggregate was down at about three and a half years down at that heart of the financial crisis as I mentioned, in 2008, because mortgages were so low in duration--but it’s now at 6.6.

So an investment in the US Aggregate gets you a duration of 6.6 and like you said, we’ve not had worse performance in the bond market in 40 years. The first quarter [of 2022] the US Aggregate, we were down almost 6 percent. It was the worst quarter since 1980. So it’s forty years since the bond market has performed this poorly. The US Aggregate had generated negative returns in seven of the last eight months, which is unheard of in fixed income.

So you know it’ll have a tendency to really right the ship. It’s supposed to be a fairly stable investment, but when rates move directionally like this for an extended period of time, which we’ve not seen for a long time, it hits every part of the bond market. And look, you can look at every asset class, not just US Aggregate, whether it’s high yield, whether it’s global bonds, whether it’s emerging markets. And we all want to know what Russia did to that situation, but it’s been a tough quarter for fixed income investing.

Rick Ferri: So we’ve talked about duration and duration as a measure of interest rate risk and the fact is when rates go up the duration of mortgages goes up but the duration of coupon bonds like Treasuries actually goes down.

Nick Gendron: Correct. You kind of know how much a regular bond is going to move as far as duration, just based on a mathematical calculation of a bond, and they’ll move, but not as significantly as a mortgaged-backed, and the thing with mortgaged-backed securities is they’re dependent on the prepayment model you’re using as well. So you can argue over what the duration of a mortgage-backed security is, based on, you know, we’ve got a great prepayment modeling team here at Bloomberg, but if you look at a rival index provider it’s going to say the duration of the mortgage universe is different than what we say.

Rick Ferri: Well let’s talk about that because really in a way we’re talking about how do you price bonds. And we know that a lot of the bonds in the US Aggregate, in fact all bonds, all bond indices, have bonds that don’t trade. Unlike stocks, a lot of the fixed income doesn’t trade. So these models are pricing the bonds, correct. And so you have to actually price each bond every day even though it’s not trading?

Nick Gendron: That’s right. So you know there’s different price providers that we’ve used over the years. Our what’s called our BVAL team here at Bloomberg is Bloomberg’s pricing service, and they provide all the pricing for the bonds in the index. Prior to us joining Bloomberg, we used a combination of vendor pricing. But a lot of it came from our Barclays, or Lehman, traders who were trading the bonds all the time and we did have a pricing team back then which would work with them and price the index.

So the pricing of the index has evolved over time and now we’re using pure BVAL prices. They do a great job of pricing the universe but you’re right for the bonds that you are able to see, you know, trades on every day or bids or offers on every day, you can price those very, very well.

Part of the universe does have to be model price, like if a bond of a certain issuer; if you can price that one fairly well but the other one doesn’t trade you’re going to have to deduce sort of a movement of that bond, or what’s called the spread of that corporate bond relative to treasuries fairly in line with how the bond of the other bond of that issuer moved.

There’s other ways to model bonds as well as bonds of a similar quality, industry, that type of thing. But universes like Treasuries are very easy and liquid and you could come with really, really quality prices, and for most of the bonds in the index you could definitely have observations for, but for others you’re going to have to model price for sure.

Rick Ferri: Now the index funds themselves, the ones who are managing the index funds, they also have to price their portfolios on a daily basis, and some of the bonds in those portfolios may not trade on a daily basis so are they using the same pricing or is there some discrepancy between what they’re using and what you’re using?

Nick Gendron: Yeah, that’s a great question and probably a great one for Josh as well, but yeah they have to use services or pricing services to price their portfolios. In some cases they will use BVAL because they believe in the quality of those prices and they will be and they’ll use BVAL. Not every client does. There’s many other competitive pricing services out there that do a good job and clients use who they feel are the right pricing vendor for them. But you’re right in saying that if an investor is using a different pricing service than the index you could be exactly matched on every constituent of the index but still show different performance than the index because of the difference in pricing services. So, you know, it is not an exact science, that’s for sure. So you will have some tracking [error] here because of that.

Rick Ferri: So last question and we’ll wrap it up. And this has to do with derivatives, if you will, of the US Aggregate, and I know that Vanguard uses a float-adjusted.

Nick Gendron: As far as the float-adjusted index, there’s bonds in the market that are held by the Fed and certainly as part of the financial crisis the Fed’s always bought Treasuries and then, just in all transparency, those have always been excluded from the US Aggregate from day one. That’s just part of our methodology because it was a very consistent pattern and it’s been baked in as part of the methodology forever. So the amount of Treasuries in the float-adjusted and in the standard US Aggregate are exactly the same, okay.

The mortgages though were another debate back in 2009. Once the Fed started buying mortgages should we take them out of the index or should we keep them in, because they had never been in the game before. Back then nobody knew how long it was going to last, nor did we actually have the information at a CUSIP level, especially early on, to start taking them out we just can’t guess.

Over the course of time and the information became more transparent, but when we were trying to make a decision about what should we do with all this, with the Fed holdings of MBS [Mortgage-Backed Securities], there was again a lot of good conversation about this with our clients due to the uncertainty of how long the Fed was going to be in the game. Should we take out all the bonds and then have to put them back in and that type of thing. There’s a lot of good points that are brought up.

So that’s how the float-adjusted version of the US Aggregate was born was the main difference then the amount of mortgages in the two indices. So if I could give you a couple of stats it’s the mortgage part of the index, our US Aggregate Index has about 30 percent in securitized, and that’s mortgages plus only of ABS [Asset-Backed Securities] and CMBS [Commercial Mortgage Backed Securities]. The Float-Adjusted Aggregate has 22.3 percent. So we’re almost seven and a half percent less in terms of securitized debt in the float-adjusted index and that means the other sectors just go up a scaled amount so there’s more, there’s basically more corporate bonds in the Float-Adjusted Aggregate and there’s more treasury bonds in the Float-Adjusted Aggregate.

Rick Ferri: So which one outperformed this last quarter?

Nick Gendron: I looked at that and the difference was only seven basis points.

Rick Ferri: Oh, was that all it was. Okay.

Nick Gendron: It really was minor. Now again, I haven’t done all the attribution on it but as of right now the difference in--you would think the different, the duration of the--because we’ve talked about mortgages being at their highest duration in a while – but the curious part is the duration of the other components is higher than the overall duration of the US Aggregate. So even though securitized mortgages are at their highest in a while it’s still not the same duration as the other components.

So that being said, the Float-Adjusted Index is about 0.15 years longer in duration than the standard US Aggregate is right now.

Rick Ferri: So not much. Well Nick, it’s been extremely educational. Thank you so much for being on Bogleheads on Investing and we greatly appreciate all the insights, and good luck with the next 30 years in this industry.

Nick Gendron: Really appreciate you having me on today, and look forward to speaking with you soon.

Rick Ferri: Our next guest is Joshua Barrickman, Principal and Head of Fixed Income Investing at Vanguard. So let me introduce Josh Barrickman. Welcome to Bogleheads on Investing.

Josh Barrickman: Oh thanks, Rick, thanks for having me.

Rick Ferri: Josh, you’ve been at Vanguard since 1998 and now you’re the head of bond indexing, managing about a trillion dollars in assets. So it’s a big responsibility, but before we jump into bond index funds and the Total Bond Market Index Fund could you tell us a little bit about yourself, a little about your background. How did you get into this position?

Josh Barrickman: Yeah, sure, happy to. So I grew up in Ohio and I went to school out there, studied finance. Made my way east to go to business school and started up with Vanguard in 1998 in one of our tax departments. Did that for about twelve months and got an opportunity at that point to move to the fixed income group as a trader for our municipal bond funds. So I was able to do that for three years, trading various different asset classes within municipals.

And then in 2002 had the opportunity to move over to our fixed income index team which at the time was a rather small team, maybe eight folks total. But a really great opportunity for me, coming up to really get to work with some luminaries in the field of indexing. Folks like Ken Volpert, Craig Davis, Chris Alwine. Was able to grow my career on the index desk, various roles as trader, portfolio manager across a lot of different asset classes.

Then in 2013 took over as head of the desk and have really been in that role ever since. The index desk in particular has been really a dynamic place to work and have a career just with the amount of different markets that we’ve banded into, ETFs. Kind of list goes on and on in terms of how the business has grown and changed over the time I’ve been there. It’s been a great place to have a career.

Rick Ferri: How many different funds are you responsible for managing, both the US and internationally?

Josh Barrickman: Yeah. So the global footprint for bond index is around 80 - 85 different mandates. Kind of depends how you classify certain things, but yeah about 85 mandates and just around a trillion dollars in AUM [Assets Under Management].

Rick Ferri: And how much of that is US versus outside the US?

Josh Barrickman: Yeah, the bulk of it is definitely in the US. I would say the breakdown is probably around 80/20.

Rick Ferri: And the flagship product in the US is the Total Bond Market, all share classes.

Josh Barrickman: That’s right.

Rick Ferri: And by the way you have different Total Bond Markets, correct? You have the Total Bond Market One, you have the Total Bond Market Two, you have the Total Bond Market ETF. How many different Total Bond Market funds are there?

Josh Barrickman: There’s really two. There’s Total Bond Market and there’s Total Bond Market Two. The ETF you can really think of as an extension or different share class within Total Bond Market One. It’s really just a share class of that fund.

There’s a Total Bond Market Two product which is really in place to serve as the bond option for some of our multi-asset strategies.

Rick Ferri: Is there any difference between how they’re managed?

Josh Barrickman: No, they’re going to be pretty close to one another in terms of overall strategy and composition. For different reasons, for cash flows and things like that you will have some deviations but we’re talking very much at the margin.

Rick Ferri: One might ask a question about if one fund, one bond index fund, Total Bond Market Index Fund, needs a bond and Total Bond Market Index Fund number two has a bond is it legal to move it from one fund to the other at NAV [Net Asset Value]. Can you do that?

Josh Barrickman: It is. It is currently. Those rules are likely changing in the short term but there is a process that we can go through that allows us to cross trade between funds. There’s an approved process with our risk team to make sure that everybody’s being treated fairly, but as of right now that is doable

Going forward, like I said, the rules will be changing around that.

Rick Ferri: Is that because of the SEC or because of Vanguard?

Josh Barrickman: An SEC rule change, yep.

Rick Ferri: Oh, interesting. So the bond would actually have to go out of one fund to someplace else and then come back into the other fund.

Josh Barrickman: Yeah. The two funds would not be able to cross trade directly with one another and which, given the nature of the bond market, it’s not a guarantee that that particular bond would make its way back to the other fund. There’s a lot of friction in the fixed income markets relative to the exchange traded market where certain bonds are going to be available on certain days and they may not trade other days. So you can never be sure that you’re going to be able to get the bond that you want when you want it.

Rick Ferri: You have a short-term bond index fund, intermediate term bond index fund, and so there’s different pieces of say, the aggregate bond market that are broken up into different maturities, different credit ratings and right now if a bond, let’s say that was in the intermediate term corporate bond fund got to a certain maturity where it would normally be sold, and the short term corporate bond fund index one needs it, you could move it in, but what you’re saying going forward you may not be able to do that.

Josh Barrickman: That’s right. At least not directly in between the two. Again, an SEC rule would prohibit that going forward.

Rick Ferri: Is that rule in place? Are you just anticipating it’s going to happen?

Josh Barrickman: It’ll be in place I believe in September of this year.

Rick Ferri: Do you think this will add costs to managing these portfolios.

Josh Barrickman: We’ve gone through a lot of different scenario analysis of how we can handle this and at the end of the day it’s pretty de minimis. In some ways, it adds opportunity for us to be a little more strategic about how we move bonds from one fund to another. Throughout the month we may have opportunities because of new issues we might be overweight credit and that might be a decent time to sell out of those bonds that you described that might be falling out of that benchmark, and things like that. So we’ve kind of gone through a lot of different iterations and feel like we’re in a pretty good place to have a small, if any impact to the funds.

Rick Ferri: So the Total Bond Market itself, the index that you’re tracking is the Bloomberg US Aggregate Float-Adjusted Index and that index has 12,500 bonds in it according to the latest information on the Vanguard website, the Total Bond Market Fund has about 10,150 so there’s a discrepancy there of maybe 2,300 bonds. And so why would there be such a large discrepancy, whereas if this was a stock index fund it would generally be almost every stock that trades out there. So why is it not that way with bonds?

Josh Barrickman: Yeah, it’s a good, good question Rick. I mean the example I think that clarifies it a bit is you’ve got stock index funds that have securities that trade on exchange. So something like an S&P 500, it’s quite easy to go out and buy those 500 stocks in the right proportions and get tracking that benchmark. What you don’t have in the bond market is that same exchange traded mechanism. So everything in the bond market trades over the counter, which really means that as a trader or portfolio manager you need to go out and find the bonds that you need to trade. And you also have a dynamic that the fixed income market is really a buy and hold market, a lot of securities that don’t trade, that get purchased at new issue and get– the term is put away – they get put in someone’s portfolio and you don’t see them come out.

So what sort of happens then is because of those dynamics, myself, my team, we need to go out and build samples of the markets to replicate the major risk factors to ensure that we’re going to get tight tracking. But we need to do it in a way that understands that there are limitations to what we can and can’t buy and we have to be, by definition, overweight some things and underweight other things. The team here will break the market into sort of sub-components and we have experts that will be building the sample within the sub-component with a bent toward trying to add a little bit of value at the margin. Tracking is always job one for us, but understanding that we have to be overweight some places and underweight others, we try to do that pretty deliberately, leverage our credit resources, credit research teams, as well as our traders’ expertise to continually buy bonds that are a little bit cheaper and sell bonds are a little bit richer and over time you have that accrued in the funds.

Rick Ferri: And then your analysis, how much of that has actually accrued to the funds? Did you have like basis points or something you could point to and say, ”Yes, we actually added this much value by doing that type of trading”?

Josh Barrickman: Yeah. I said a typical year we’re not talking about huge numbers here in terms of basis points. One or two basis points would be a pretty typical year. And first of all, we’re generally able to overcome our transaction costs and then eat into the expense ratio by maybe a basis point or two basis points. So not huge in terms of basis points but when you convert that into dollars and cents you’re talking about some pretty big numbers

Rick Ferri: So the Total Bond Market has an ETF attached to it as a share class but that trades differently than cash coming in to the total bond market fund itself. And the ETF share class according to the data on your website is about 83 billion or so of that 300 in the Total Bond Market. What I’m really curious about is does it enhance the fund in some way. In other words the performance, or does it lower the cost because you have this ETF share class?

Josh Barrickman: Yeah, like you mentioned, it’s really just a separate share of the The Total Bond One fund. So a lot of the ways we’re indifferent about the ways cash comes to us. If it comes to us through the mutual fund it’s more traditional in cash. If it comes to us through the ETF channel it’s going to be more in-kind bonds. Having the ETF attached, it has a couple of nice benefits for us. It allows us to add additional diversification through the ETF channel as we negotiate custom baskets with market makers and we’re taking those in every day and we’re able to take those in on the bid side of the market so in a way we’re able to grow the asset base without explicit transaction costs attached to it. And there’s also some tax deferral; benefits through the in-kind process and when we do have redemptions we’re able to send out some of the lower cost lots that we might otherwise have to trade at a gain. So those couple things are additive to the mutual fund shareholders from the ETF.

Rick Ferri: Let me circle back to just the observation about the titling of the Total Bond Market Fund, and the reason I circle back to this is because when I interviewed Nick from Bloomberg, they call it an Aggregate Bond, a US Aggregate Bond Market Index, but Vanguard calls the fund a Total Bond Market Index. So could you explain why? Why doesn’t--I guess my question is why doesn’t Vanguard call it the US Aggregate Bond Market Index. Why is it the Total Bond Market?

Josh Barrickman: Yeah, it’s really the broadest fund that we offer. At least that’s purely US focused. It’s really probably the investment grade component of it that we would say is the total investment grade market. You know some of the components that people might argue should be included would be things like high-yield and Emerging Markets but then you’re sort of straying of this investment grade mandate and frankly, I think people have certain expectations of bonds that probably align a lot more with investment grade performance versus being in something that’s high-yield or Emerging Markets that at times are going to trade at a lot more with a higher beta to equities at times. So it’s really the investment grade piece that we’re wrapping that total label around.

Rick Ferri: I think it was around 2010 Vanguard decided that they wanted to change the index that they were tracking slightly to a float-adjusted index and this is different than your competitors like iShares. Why did Vanguard make that change, or made that decision to go that direction?

Josh Barrickman: Sure. In terms of the float adjustment, the standard US Aggregate has always adjusted for Fed holdings of Treasuries so if you compare the Aggregate versus the Float Adjusted that component is the same. Where there was a deviation was when the Fed started to buy mortgage securities post the global financial crisis and start to take those onto their balance sheet, the decision was made that the top level Aggregate was not going to adjust for those.

We felt pretty strongly that it would be best practice to adjust for float that’s being taken out of the market. Really the biggest difference you see between the two is the weight in mortgages is quite a bit lower in the Float Adjusted but that then redistributes the entire pie so you’ll get a bit higher in credit exposure, you get a bit higher in treasury exposure. We felt it was best practice. We don’t want to be trying to buy in markets where we know the Fed is out there in somewhat a non-economic way taking supply out of the market.

But it’s not perfect, right? You could argue like I said, it’s a buy and hold market. There are a lot of bonds that are on the balance sheets of foreign banks, insurance companies or pensions that are probably never going to trade but the data to really do something like that just really isn’t that reliable or available.

So we felt it was a good step. We felt it was the right step for our investors. Looking at it over a five-year lookback, Float-Adjusted has outperformed slightly--hasn’t been dramatic--but a slight outperformance over a five-year period. What you will see too is as the Fed is going to unwind qualitative easing and let mortgages roll off, and let Treasuries roll off and potentially, if they get more active, actually sell, what you will see is that float come back into the market and you’ll see a convergence between the Float-Adjusted Aggregate and sort of the standard Aggregate.

Rick Ferri: Let’s talk about return for a minute because it has been a difficult market here for investors. I think Nick was telling us that he had to go all the way back to I think the 1970s to find a period of time when in one quarter the aggregate bond market lost as much as it did in the first quarter of 2022. So I want to talk about the different elements of return-- coupon yield, roll yield, capital appreciation--all the things that go into the return.

Josh Barrickman: Yeah, sure. Really, when you’re investing in bonds you’re generally investing to earn that yield and that yield, it’s really a combination of coupon as well as the dollar price of the bonds in the portfolio at the time, and sort of taken together that will give you a yield and that should be a pretty good estimation of what you should expect to earn over at least the short term.

We’ve obviously come from a period of really low rates. A lot of times you’ll think in terms of break-even spread, spread moves or break-even interest rate moves and when you’re at such a low level of yield, a very low hurdle rate in terms of the yield that you’re looking to earn or expecting to earn, it doesn’t take much in terms of a backup in rates before you overwhelm that yield and you actually go negative in total return.

And that’s what we’ve seen obviously over the past couple of quarters as inflation has kicked up. And the Fed has been very vocal about their plans. The golden rule that you always have to keep in mind is that rising rates aren’t always a bad thing. It really has to do with your investment horizon and the product you are in. So rule of thumb would say that if you have an investment horizon that’s longer than the duration of your fund, you should actually welcome higher rates because what’s going to happen is you’re going to have an opportunity as yields go higher you’re going to reinvest and that will continue to sort of accrue and compound through the life of that investment. So, like anything, it’s always important to make sure you’ve got the right product. It’s within your risk tolerance or risk budget and you’re able to ride it out because you are in the right product.

Rick Ferri: I want to talk about the concept of roll yield where you’ve got a yield curve now that’s very steep and the total bond market and the US Aggregate Index, once a bond gets to one year it comes out of the index because now it is a cash element, it’s a cash security. If you’re buying these at five years or six years and you hold it until one year but you don’t hold it to maturity there’s an excess return that you could pick up if you have this normal yield curve. Can you discuss that and how that’s affecting, how that has affected the return of this fund over the years?

Josh Barrickman: Just going back to this idea that we’re building samples. We make a lot of active decisions on a daily basis within kind of the construct of bond indexing, again with tracking as the number one goal, but if something like you describe, we’re not mandated to sell something that goes under a year, and if it’s really attractive we’d be happy to hold that and maybe that’s a trade-off somewhere else in the fund, within our risks, within our risk budget. But we always have the lens of does that make sense, can we hold on to a bond that we think has a lot of value and not take a bunch of risks elsewhere.

You certainly can’t do that with all the bonds that are going to fall under a year or else you would end up taking a curve bet somewhere along the yield curve in the fund. But there is a lot of discretion for us to do that when those opportunities arise.

Rick Ferri: I got a question that came up with Nick and it had to do with pricing bonds because we already discussed the fact these bonds you have in your fund are put away. They don’t trade but they need to be priced every day. And Nick was telling us about the services they use to price their bonds and does Vanguard use the same services, or is it different, and if it’s different how does it affect the NAV [Net Asset Value] of the index versus the portfolio?

Josh Barrickman: In most cases, we don’t use the same service. There are some pockets where we do. For us as an index fund provider that would probably be the lowest tracking option for us would be to use whatever value that our index providers come up with. We found over the years that we want to take a little bit more of a broader look and use a variety of different pricing services. So we bring in two or three or more prices every day for different markets. Our pricing team within our fund accounting group will do the due diligence to really quality check all the different pricing sources and use the ones that we really think are most accurate for that particular sector in that particular fund.

Rick Ferri: Let me ask another question, maybe a little bit tougher. When the bond market has a bad day and credit spreads just widen very rapidly and the liquidity just dries up, ETF prices plummet and sometimes ETFs close at much lower prices than their fund, their index fund equivalent. I think we might have seen this back in 2020; might have seen back in 2007 -2008 where we saw this big gap between market price of the ETF at close and the actual NAV [Net Asset Value] of the open-end fund. And I think that you know a lot of people try to explain it. A lot of people are saying that this is actually fair. But number one, could you explain what happens and your view of all that?

Josh Barrickman: Sure, yeah. So the example that you probably know or at least is most fresh in mind is it’s March 2020 when you saw for a small period of time bond ETFs closing at relatively large discounts to net asset value. I think the first thing I would say is that was a really unprecedented period of volatility for the fixed income ETFs and it was a pretty big test for how resilient they would be. I guess I’ll go back to first of all the diligence that we put into our net asset value makes us feel really good about where we’re coming in every night with net asset value pricing.

The deviation on the ETF side has a lot to do with sort of the price of liquidity at that time in the marketplace and the demand for sort of instant liquidity taking place. When you have a market that’s somewhat frozen up and then you think about okay well you know there should be this arbitrage mechanism that brings things back in place but then you get to kind of think about the state of the market, where it was, and the arbitrage trades that would need to happen to close up that gap and that would sort of involve someone going out and buying shares in the market, redeeming them to the fund and getting bonds in return. And in an environment like that from hour to hour, from minute to minute, you don’t really know what those bonds could be worth. It could gap lower by two points by the time you get around to actually liquidating, and trying to effect that arbitrage. So, there’s just so much uncertainty and friction that that arbitrage mechanism definitely gets weakened a bit in those times

Big picture, there were some small blips but for the most part we were very encouraged of how the fixed income market behaved and how resilient it was and how big a part of it was in terms of kind of ultimate price discovery over the course of a few months as the market tried to right itself and work out some of the volatility and the dislocation that we had seen.

Rick Ferri: So most people who are buy and hold investors, should just kind of ignore these daily fluctuations, unless perhaps you wanted to do some rebalancing. In which case, if you wanted to do some rebalancing and that day in March where things went crazy and the gap between the trading price of the ETF and the net asset value of the open-end fund was so wide that it would have been better off selling the open-end fund if you had those shares rather than the ETFs.

Josh Barrickman: Right. The open-end fund would have probably been a better option at that time but there’s reasons that people hold the ETF and some of it is this instant liquidity, you know, getting out at midday. We also have some frequent trading policies that would restrict folks from coming into and out of the Total Bond mutual funds which wouldn’t occur in the ETF. So there’s a lot more flexibility there as well so there’s a little bit of trade-offs on both sides.

Rick Ferri: Are you finding it more difficult trading bonds with the current environment? I’ve been talking about higher interest rates and so but this is a great--some illiquidity in the markets. Is it more difficult for your desks?

Josh Barrickman: I wouldn’t say it’s anything that’s unexpected or out of the ordinary in a period of volatility like this. I think any time you go through this there’s a bit of a price discovery process. It takes a market a while to settle in, sort of back to more normal levels. So there’s a bit of it for sure, but yeah, I would say it’s well within what we would expect.

Rick Ferri: You're an important person. You’re managing a lot of money for a lot of people. Is there anything you want to add to this conversation?

Josh Barrickman: Yeah, I mean I could just maybe offer a couple thoughts. We’re obviously talking about Total Bond today but Vanguard has a full line-up of both active and index products on the bond market that really offer investors with a lot of options and flexibility to tailor that bond exposure. Yeah, we do believe in Total Bond as a core, but core doesn’t mean 100 percent if somebody is of the mind that they want more corporate exposure or they want a shorter duration or a longer duration. We have a lot of great options to supplement that exposure and make sure people get the risk that they’re comfortable with and the risk that kind of fits their long-term asset allocation. So again Total Bond we think is a great core-- but there’s a lot of other sort of building blocks we would call them--to add on to build a bond portfolio that gets you really close to your objectives.

Rick Ferri: Josh, thank you so much for your time today. Really appreciate the insight and I really appreciate what, everything that you and your team do for us all at Vanguard.

Josh Barrickman: Oh thanks, Rick. It’s been great.

Rick Ferri: This concludes this edition of Bogleheads on Investing. Join us each month as we interview a new guest. In the meantime visit boglecenter.net, bogleheads.org, the Bogleheads wiki, Bogleheads twitter, listen live each week to Bogleheads® Live on twitter spaces, Bogleheads YouTube channel, Bogleheads Facebook, Bogleheads reddit. Join one of your local Boglehead chapters and get others to join. Thanks for listening.

About the author 

Rick Ferri

Investment adviser, analyst, author and industry consultant



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