Bond Index Funds - A Synopsis By Sam Henry June 30, 2000

It is fitting that a detailed discussion about bond index funds should
begin by mentioning John Bogle and Vanguard Mutual funds. These are two forces that originated bond index funds and index funds in general. The first bond index fund was in the early conceptual stages in 1985 when an article in Forbes magazine discussing the inability of high-cost bond fund managers to match the bond market indexes asked, "Vanguard, where are you when we need you?"

This was all the encouragement that Bogle and company needed. By the next year Vanguard's Total Bond Market Index (VBMFX) was up and running. SEI Funds also started a bond index fund that year. In 1991 Galaxy Funds opened an index fund of government long bonds and Mainstay Funds started its long-term bond index. Also in 1991 Charles Schwab Co. opened its Short-Term Bond Market Index. In 1994, Vanguard created the first series of bond index funds of varying maturities, short, intermediate, and long.

Although John Bogle didn't see any pressing need at the time for this series of bond index funds, he said that he was anticipating the market for bond index funds that he knew would develop. Today there are 29 bond index funds. Vanguard's are currently preeminent among them. Their four bond index funds have $15.8 billion in assets-about 75% of all bond index fund assets. And they are reportedly also the largest bond fund managers in general with $80 billion under management.

Fund Name	Category	Load %	Exp. %	YTD %	1 Yr %	3Yr %	5 Yr %	10 Yr %
BNY Hamilton Intermed. Inv. Grade Inst. Index	Intermed.	No	0.8	-0.01	0.27	4.26	-	-
Barclays Global Inv. Bond Index	Intermed.	No	0.23	1.84	1.54	5.45	5.42	-
Dreyfus Bond Market Index Basic	Intermed.	No	0.15	1.24	1.45	5.63	5.58	-
Dreyfus Bond Market Index Inv.	Intermed.	No	0.40	1.14	1.28	5.34	5.29	-
E*Trade Bond Index	Short	No	1.50	0.20	-	-	-	-
Fidelity U.S. Bond Index	Intermed.	No	0.31	1.78	1.84	5.73	5.89	7.85
Firstar Short-Term Bond Institutional	Short	No	0.50	1.97	4.14	5.39	5.61	6.70
Firstar Short-Term Bond Retail	Short	3.75	0.75	1.87	3.88	5.13	5.35	-
Galaxy II US Treasury Index	Long	No	0.41	3.29	2.88	5.90	5.66	-
Mainstay Instl. Indexed Bond Instl.	Long	No	0.50	2.01	1.65	5.02	5.21	-
Mainstay Instl. Indexed Bond Instl Svc.	Long	No	0.75	1.91	1.36	4.76	4.96	-
Maxim Bond Index	Intermed.	No	1.70	1.50	2.52	4.49	4.87	-
Maxim Loomis Sayles Corp. Bond Index	Intermed.	No	1.85	0.94	1.83	5.98	8.50	-
Mercantile Bond Index Inst.	Intermed.	No	0.79	2.04	1.73	3.47	-	-
Mercantile Bond Index Inv.	Intermed.	4.75	0.77	2.12	1.81	5.20	-	-
Mercantile Bond Index Tr.	Intermed.	No	0.42	2.25	2.22	5.74	-	-
Merrill Lynch Aggregate Bond Index A	Intermed.	No	0.35	2.55	2.91	5.44	-	-
Merrill Lynch Aggregate Bond Index D	Intermed.	No	0.60	2.46	2.66	5.18	-	-
Northern Inst. US Trs. Idx A	Intermed.	No	0.26	3.50	3.09	6.10	5.86	-
Prudential Bond Market Index Z	Intermed.	No	0.40	1.55	1.56	-	-	-
SEI Index Bond Index A	Intermed.	No	0.38	1.85	1.84	5.52	5.60	7.19
Schwab Short-Term Bond Mkt Index	Short	No	0.35	1.75	3.49	5.01	5.16	-
Schwab Total Bond Market Index	Intermed.	No	0.35	1.09	1.63	5.48	5.52	-
Vanguard Short-Term Bond Index	Short	No	0.20	1.69	3.46	5.44	5.60	-
Vanguard Intermediate-Term Bond Index	Intermed.	No	0.20	1.05	0.45	5.20	5.47	-
Vanguard Long Term Bond Index	Long	No	0.20	3.48	0.26	6.74	6.31	-
Vanguard Total Bond Market Index	Intermed.	No	0.20	1.75	1.91	5.66	5.88	7.63
Vanguard Total Bond Market Index Inst.	Intermed.	No	0.10	1.80	2.02	5.76	-	-

Replicating, to an extent, the success they achieved with stock index funds, Vanguard, and 17 competitors have nurtured a small but steadfast base of bond index fund customers. Although this customer base has not grown as fast as that in stock index funds, bond index fund managers now handle $21 billion. Bond index fund assets have grown slowly in part because report of the virtues of fund indexing has for the most part spread through word of mouth, and because low-cost index funds rarely budget much for sales and marketing.

Bond index funds occupy a fairly small niche in the world of mutual funds; only 3% of all bond fund assets are in bond index funds and these assets are held disproportionately by institutional investors, who keep about 25% of their bond fund assets in bond index funds.

How they Work

Bond index funds use a technique called "sampling" to fill out their portfolios. Total Bond Market index funds, like those managed by Vanguard and Charles Schwab Co., as well as intermediate bond indexes like the Maxim Bond Index, usually aim to trace the performance of the Lehman Brothers Aggregate Bond Index. This benchmark is a collection of 5,545 bonds (as of 12/31/99) from the Treasury, corporate, mortgage backed, and international U.S. dollar-denominated debt sectors.

Various other short, intermediate and long duration bond index funds trace subsets of this index. For instance, the Vanguard Short-Term Bond Index Fund traces a subset of this index called the Lehman Brothers Mutual Fund Short Government/Corporate Index, which holds 1,874 bonds. Now, it wouldn't be cost-efficient for managers to include, say, all 5,545 issues from the Lehman Brothers Aggregate index, among other reasons because they would forgo very substantial volume discounts at auction.

Instead they use sophisticated computer programs to select a cross-section of issues from this Lehman Brothers index that is representative of the index as a whole in terms of duration, cash flow distribution, sector and quality weights, and other characteristics. For instance, at times when 30% of the Lehman Brothers Aggregate Bond Index is composed of mortgage-backed securities, the managers of Vanguard's Total Bond Market Index would invest about 30% of the fund's assets in mortgage-backed securities that have similar characteristics as a group to those in the Lehman Brothers broad index. As of 12/31/99 the Lehman Brothers Aggregate Bond Index was composed thus:

U.S.Government Bonds	Corporate Bonds	Mortgage-Backed	U.S. $ Instl.
41.6%	18.2%	35.6%	4.6%

International U.S. dollar denominated bonds are issued by foreign governments and companies in U.S. dollars, usually in order to attract U.S. investors.

Hardly "Passive" Management

Kenneth Volpert, senior manager of Vanguard's bond index funds, likes to say, "People say that these funds can be run by a monkey. That's not true." He understates his case. The truth is that these managers tinker a lot with their portfolios, though not as much so as the so-called "active managers." Usually bond index funds hold only a little more than 80% of their assets in bonds enumerated in the Lehman Bothers index. The other 20% of the bonds have characteristics - like maturity, credit quality, and issuer type-similar to those in the index, but not the actual issues enumerated there.

And, as the Vanguard bond index funds prospectus puts it, "To the extent that the funds invest outside of the index, they may employ active management strategies. The index and non-index securities, in combination, will have characteristics and risks similar to the index." The prospectus goes on to authorize further managerial latitude for these managers. For instance, Vanguard fund managers nearly always make use of an option in the prospectus called "corporate substitution," whereby managers can overweight particular types of corporate bonds relative to their representation in the index.

A favorite gambit is to snap up corporate issues late in the fourth quarter after they've been dumped by Wall Street firm, as happens almost every year. (Business Week online 3/13/98). Vanguard bond index funds limit corporate substitution to bonds with less than four years remaining to maturity, and each bond index fund limits corporate substitutions to about 15% of assets.

It's astonishing how far beyond the indexes these prospectuses allow their fund managers to go. Vanguard's short, intermediate, and long term bond index funds are at times composed of a basket of securities, 35% of which are outside the Lehman Brothers subindexes, including smaller public issues or medium term notes not in the index because they're too small. These funds managers may also buy money market instruments and some derivatives in order to manage cash flow, to reduce transaction costs, or to take advantage of arbitrage opportunities when they arise. One example of such an arbitrage opportunity occurs when Treasury bond futures prices are significantly lower than the cash index. In such a situation Volpert and other bond index fund managers will often buy bond futures and hold them until near expiration because at expiration cash and futures prices are, by definition, identical. (Business Week online 3/13/98)

The Vanguard prospectus stipulates that each bond index fund's obligation to buy bonds under futures contracts may not exceed 20% of the fund's total assets. This alone would hardly be comforting to anyone suspecting fund managers of wild speculation. The fact is though, that managers at Vanguard and most other houses use these various investment options very conservatively to make up their miniscule (0.20%-0.50%) operating expenses and perhaps a couple of basis points more. It should be noted that some of the smaller bond index funds have more vaguely-worded prospectuses, although they contain otherwise similar stipulations. Investors should investigate these funds more thoroughly before investing in them and understand that under these prospectuses their managers are allowed even greater latitude from the pure indexing ideal.

Advantages of Bond Index Funds Over Actively Managed Bond Funds

Although John Bogle can personally claim credit for getting index funds off the ground, it is their evident benefits to customers that are responsible for the ongoing success of bond index funds.

Consistent Performance

Bond index funds offer numerous advantages over actively traded bond funds. Most important is their consistently superior performance. Between 1988 and 1998 Bond index funds returned 8.9% annually vs. 8.2% for actively managed bond funds, according to Morningstar. And during that time bond index funds outperformed 85% of bond funds. Vanguard's Total Bond Market Index typifies a solid bond index fund. It's current 7% 5-year average beats 87% of funds in the intermediate maturity range even though it carries a 3.8% standard deviation risk, as opposed to the 4% risk of the average fund (Dow Jones Newswire 4/4/00). Although it's true that Vanguard's bond index funds boast some of the best returns, other bond index funds, such as those offered by Charles Schwab and Fidelity, are also quite competitive.

Index Funds Enjoy Lower Operating Expenses

To a great degree, these superior returns are the result of the significantly lower expenses that bond index funds incur. Especially when bond yields are low, operating expenses represent a high percentage of any bond fund's return. Currently, the average actively-managed bond fund charges 1.1% of fund assets-a full 20% of the projected return-for management fees and other expenses. The average bond index fund charges less than half that, or 0.45%. Vanguard Group, the leader in bond index funds, charges 0.2% for its Total Bond Market Portfolio Index fund. (Investment News, 1/25/99, p.24 ff.)

Bond index funds, like their counterparts in equities, have little need for research departments; computers perform a much larger proportion of the funds' analytical work. And actively-managed bond funds almost always trade more. Consequently they incur a variety of extra expenses such as greater brokerage fees and greater capital gains tax payouts. In addition, actively-managed funds tend to keep some assets in low-yielding money market funds to cover investor redemptions.

It should be noted that managers of high-cost funds are almost certainly at times tempted to overcome this performance disadvantage by taking on additional risk. Conversely managers of low-cost funds are often able to provide competitive returns with a lower level of risk than other funds.
Also, because indexing is a buy-and-hold strategy, bond index funds often enjoy a lower turnover rate, which is expressed as the percentage of issues in the portfolio that are either bought or sold over the course of a year.

The lower costs and tax advantages of indexing, however, provide a smaller advantage for bond index funds than for stock index funds. In part that's because the current income paid by a bond fund is usually more significant than potential capital gains, and that current income is taxable. Also, because bonds mature, they must be replaced by the fund, while a stock index fund may hold some stocks indefinitely.

Particularly Tough to Beat the Market in Bonds

As mentioned above, bond index funds consistently beat actively managed funds by 0.7% or 0.8% annually. In large part this is because bond fund managers have great difficulty beating the indexes, even more so than do stock fund managers. Unlike stock funds, bond funds vary little in their gross returns. Once an investor has chosen a level of credit quality and average maturity, most bond funds will have a similar gross yield-the yield before expenses. It is really expenses more than anything that differentiates bond funds, and it is index funds that are the leaders in keeping expenses down.

By virtually all accounts, the world of high grade bonds is far more homogenous than the stock market in both risks and returns. Kenneth Volpert, a senior bond fund manager for the Vanguard Group, said that it's unlikely that a small-cap growth stock fund manager can consistently pick stocks that outperform the S&P 500 and the Wilshire 5000. But he said that chances are far worse that a high-grade bond fund manager will consistently outperform a bond index such as the Lehman Brothers Aggregate Bond Index. (Chicago Tribune 7/19/98, C3).

Alice Lowenstein, bond editor at Morningstar Research says, "The investment-grade bond area, with high-quality, highly liquid securities, is an ideal place for index investing. There's very little a manager can do. There's no surer way to outperform among high-quality bond funds than to have smaller expenses." Indexing also lends itself especially well to shorter-term corporate and U.S. government bonds, where active managers have still fewer opportunities to outperform the indexes.

Diversification

A rarely-noted advantage of bond index funds is that they are frequently more diversified than actively-managed bond funds. An index that follows the Lehman Brothers Aggregate Bond Index, as most bond index funds do, will hold a wide variety of government and corporate bonds and mortgage-backed securities, which is usually not the case with actively-managed funds, where managers often favor the more liquid issues. Even within the bond index fund subcategory of bond funds, there is substantial variance in the funds' breadth of participation. Perhaps the best fund as far as this kind of breadth is concerned, is Vanguard's Total Bond Market Index, which includes every possible maturity and sector of bonds, except junk, so no matter what sector rallies, this fund will participate.

Advantages of Bond Index Funds Over Buying Bonds Directly

* Bigger is better in Bonds There are numerous benefits to being very well-capitalized when buying bonds, including volume discounts and invitations to closed auctions. Ordinary investors can rarely take advantage of these benefits.

* Lower Investment Amounts The minimum investment for an individual bond can be as high as $10k. Realistically it probably takes about $50k to build a diversified and cost-effective portfolio of bonds. On the other hand, the minimum investment in a bond index fund is usually $500 or $1000. And a mutual fund investor can often buy addition fund shares in increments as low as about $10.

* Regular Monthly Income Most bond index funds distribute dividends monthly. Investors may choose to receive them as cash or have them automatically reinvested. Individual bonds usually pay interest only every six months and these payments cannot be reinvested automatically. This is often an important consideration, especially for retirees.

* Even "passive" bond index funds enjoy the benefits of fixed-income analysts; Vanguard has six such analysts who decide which bonds to buy and sell for their index funds and actively-managed funds. These analysts are important because few investors have the time or the expertise to manage their personal investments or to investigate all the different bonds on the market. And investors often underestimate the complexity of global fixed-income securities markets.

* Lower Commissions in Most Cases When an investor buys individual bonds through a broker, he pays a commission that's usually hidden; the quoted bond price includes a substantial commission. The smaller the investment, the greater the commission. On a $1000 bond the commission can be 5%. Sometimes the hidden costs for these bonds appear quite cryptic. Jason Zweig of Money Magazine said, "if you have $100k you're better off buying a bond fund than individual bonds because most bond brokers take an 'invisible spread' which lowers yield." He doesn't elaborate on how this 'invisible spread' works, but given Mr. Zweig's formidable reputation, one should suspect that he's referring to something substantial.

* Daily Liquidity Investors may buy and sell shares in a bond index fund on any business day. And the market for shares in many bond index funds is highly liquid. Also, most bond index funds offer options such as check writing and telephone redemption to make bond investing more convenient.

* Bond index funds Outperform Inflation-indexed Bonds in a Low-inflation Environment According to Morningstar, when inflation is low the principal of the inflation-indexed bond would remain the same and the yield would decrease. Simultaneously the net asset value (NAV) of the bond index fund would increase, but the yield would decrease. This scenario favors bond index funds.

Disadvantages of Bond Index Funds vs. Actively Managed Bond Funds: Could Retard Great Talent

Some feel that there are a number of disadvantages to the indexing of bond funds, among them the preclusion of great fund management talent. The career of William Gross of Pimco Funds is proof that excellence in bond fund management is not necessarily tied to indexing. Mr. Gross and his staff manage about $180 billion in bond assets and more than $40 billion in mutual funds, "about 5% of the assets in such funds," according to the Wall Street Journal (12/28/99). Pimco's Total Return Fund, the nation's largest bond mutual fund, has returned 9% annually over the last decade, putting it in the top 5% of its peer group. In 1999 the bond funds managed by Mr. Gross have brought in more than eight billion dollars in net new money, which is about half the new money that has come into bond funds this year. Clearly any system of investing that allows this sort of talent to lie idle is probably a system that does not have excellence as its goal.

Morningstar Study Concludes That It's Unclear Whether Bond Index Funds Are Best

In an October, 1998 study of five years' worth of bond mutual fund performance, researchers at Morningstar concluded that with taxable bond funds "managers running intermediate-term funds have managed to outrun their index on the upside, and long-term funds have done better than their benchmark on the downside." This is explained in part because most long-term bond funds are less sensitive to changes in interest rates than the index. This keeps fund returns down when bonds are rallying, as they did for much of the '90s, but keeps things stable when bond prices fall.

On the other hand, intermediate funds in general carry longer-term debt than their benchmarks, which pays off during bond rallies. The Morningstar editors went on to recommend Vanguard's Bond Index Total Market [VBMFX] and the Fidelity U.S. Bond Index [FBIDX] among bond index funds, as well as Loomis Sayles Bond [LSBRX] and Warburg Pincus Fixed Income [CUFIX] among the actively-managed funds. The study concluded that "the low costs of index funds are a real benefit in this area of the market, but we wouldn't count out active managers...Bottom line...Taxable Bonds: Could go either way."

Bond Index Fund Managers Can't Monitor Credit Quality or Call Risk as Closely

Many feel that bond index fund managers are ill-equipped to manage credit quality, that is, to select the highest quality bonds from any sector, and moreover to anticipate which are likely to be upgraded by the credit agencies. Also, active managers can potentially better control "call risk," the possibility that certain bonds with "call features" may be redeemed before maturity in a period of falling interest rates and rising bond prices. The active manager is probably better positioned to invest only in bonds that cannot be called and thereby to avoid having to reinvest assets at lower interest rates when higher-yielding bonds are redeemed.

Some Investors Don't Like Having Treasuries in Bond Index Funds

Some mutual fund customers complain that they don't need or want to pay a management fee to hold treasury bonds in a portfolio, since they can buy treasury bonds commission-free from the government. And some say they would prefer to hold only corporate bonds or GNMAs in a high-quality index fund, but that such funds don't exist at present. (Morningstar.com)

Some Investors Don't Like Having Treasuries in Bond Index Funds

Some mutual fund customers complain that they don't need or want to pay a management fee to hold treasury bonds in a portfolio, since they can buy treasury bonds commission-free from the government. And some say they would prefer to hold only corporate bonds or GNMAs in a high-quality index fund, but that such funds don't exist at present. (Morningstar.com)

Disadvantages of Bond Index Funds vs. Other Investment Instruments: Some Compelling Arguments for Holding Individual Bonds

As John J. Brennan, CEO at Vanguard said, "1999 was a useful reminder that you can lose money in Bond Funds." During that year investors learned not to "count on regular capital appreciation in a bond fund investment." In some bear market years, like 1994 and 1999, bond funds can carry considerably greater downside risk. So even though many bondholders saw the value of their investments plummet on the secondary market, and even though these bonds occasionally lost money after inflation, bond mutual fund investors reportedly lost even more money during these years.

Bond Holders Can Control Timing of Buying and Selling

By holding individual bonds, the investor chooses when to buy or sell-thus retaining control over the timing of any taxable capital gains or losses. With treasuries or investment grade corporate bonds, investors also have the assurance that they will almost certainly be paid at a certain time and at a set interest rate.

Investors Can Buy Treasuries Commission-Free Directly from the Government

Recently, the Treasury has made bonds available with no fee when investors buy them online or over the phone. Click here or here for the relevant government websites. The minimum investment through Treasury Direct is $1,000, although one would probably need about $50k to achieve a decent degree of diversification.

Five Year Treasury Study

Scott Burns, a syndicated financial editor who writes for the Dallas Morning News, among other periodicals, recently (5/2/00) published a study comparing the returns of five-year treasury bonds with the returns of various bond funds. He found that in each of the five-year periods ending in the previous six months, a five year treasury bond has yielded greater returns than an index of 20 major government securities funds. Moreover, of the 1290 bond funds with five year track records, only 282, or 22%, produced a higher load-adjusted return than a five year treasury note, and almost all of these 282 bond funds contained riskier issues from emerging markets, international bonds, junk bonds, or long-term treasuries.

The Wealthy Should Likely Park Their Money in Municipal Bonds

Bond index funds are probably not the best investment vehicles for wealthy individual investors. In general, tax-exempt municipal bonds are probably best for those whose combined federal and state tax bracket is over 28%. Although there are various actively managed funds specializing in municipal bonds, and Lehman Brothers has a municipal bond index, there is no municipal bond index fund because of complications concerning various call features and "duration options" of these bonds, among other reasons. Tax laws concerning munis vary from state to state so it might be a good idea to plug one's information into one of the following the investment planner websites: finance.yahoo.com or morningstar.com to learn more about investing in muni bonds.

Bonds May Not Diversify As Well

It may be that bond index funds and fixed income investments in general have lost some of their diversifying capabilities in recent years. In his book Stocks for the Long Run, Jeremy Siegel argues that the once negative correlation between stocks and bonds is now much more positive. Also, the presence of high yield (junk bond) debt in some full spectrum bond index funds make these funds correlate more closely with stocks, especially, perhaps, when stocks are at such high valuations.

Inflation-adjusted Bonds Work Well in Inflationary Times

In times of inflation, Inflation-adjusted Bonds offer protection against inflation while bond index funds do not. With I Bonds, as the Consumer Price Index rises, principal remains the same but interest rates increase. Conversely, bond index funds would decrease in net asset value (NAV), but yield would eventually increase. This scenario favors I Bonds.

New Products in the Bond Index Fund Arena

On June 6, 2000, Barclay's Global Investors announced that they were planning to launch the first exchange-tradable index funds focusing on the bond market. If all goes according to plan, shares will begin trading in the spring of 2001. Ten days later, on June 16, Barclays actually began trading eleven exchange-traded equity index funds that are each centered on ten different industrial sectors, such as Chemicals, and Healthcare, and one catch-all equity offering, their Total Market Index.

Some analysts find it "questionable whether bond index funds are easy enough to price and trade throughout the day for a firm to use them for an exchange-traded product." (Wall Street Journal 6/6/00) About exchange-traded bond index funds, there is also the concern that proportionately fewer traders trade bond funds short-term, and thus there might well be less demand for such an exchange-traded fund.

Still, these kinds of funds could potentially pose a great threat to more conventional index funds and mutual funds in general, not least of all because their expenses should probably be lower. For instance, Barclays iShares, an exchange-traded index fund that tracks the S & P 500, charges only .10% annual expenses, half of what Vanguard charges to manage its Total Bond Market Index fund and its other three bond index funds.