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The best Vanguard bond funds for UK investors

Who would’ve thought people were so interested in bonds? Certainly not me. After this post: ‘The best Vanguard index tracker funds for UK investors’, which is now by far and away the most popular post on this site, the number one comment I received was “This is all great stuff, but what’s the best Vanguard bond fund to invest in?”

Introduction

 

 

Should you own bonds?

 

Before answering the question of what the best options are for a Vanguard bond fund, it’s first useful to consider whether bonds still serve their purpose in portfolios, given the ultra-low interest rate environment we’re in. There’s no point recommending bond funds if bonds aren’t worth owning.

With that in mind, my last post: ‘What’s the best crash protection for your portfolio’ examined whether, with yields verging on negative across most developed markets and durations, bonds still deserved a place in portfolios as either a source of uncorrelated return, or a source of protection against a crash.

To summarise, the conclusions on bonds were:

  • Bonds currently have an incredibly low, and in some cases negative, expected return.
  • They’re likely to offer less protection against a crash now than in the past.
  • But there are few alternatives which offer the same level of potential protection, while also being liquid, transparent, and cheap to hold during rising markets.
  • The overall conclusion of the article was that I was happy diversifying my diversifiers, splitting the allocation up between government bonds, inflation-linked bonds, cash, and perhaps gold (although I’m still unsure on gold: see ‘Should you invest in gold as a UK investor?’).

So now we’re happy with holding bonds in our portfolio, or at least begrudgingly accepting of owning them as the least-ugly sister, let’s have a look at Vanguard’s options.

We’ll be looking to find two bond funds for our portfolio:

  • A global government bond fund
  • A UK index-linked gilt fund

For the purposes of this article, we’ll be assuming investors are using Vanguard’s own platform.

 

The starting point

 

To start our search for the best Vanguard bond funds, we begin with the funds offered on Vanguard’s platform. In total, they offer 25 bond funds, but we can narrow our search down by applying a few filters of our own.

 

Active vs Passive

 

Firstly, we’ll be filtering out any actively managed bond funds.

There is considerable evidence, which I’ve written about here: ‘Active vs passive performance – bonds’, which shows that active management is no better for performance in the bond market than in the equity market.

In summary, I’m an advocate for passive management because it:

  • Has outperformed 90%+ of active managers
  • Has lower fees
  • Is more transparent
  • Is simple and easy to understand
  • Requires no forecasting
  • Has no minimum investment requirements
  • Has no capacity constraints
  • Doesn’t require picking winning fund managers in advance
  • Doesn’t require deciding whether to stick with underperforming managers
  • Doesn’t incur the risk of a fund manager(s) having to suspend their fund or, worse, liquidate
  • Has much lower levels of conflicting interests
  • Becomes more powerful the more people adopt it

Although the active vs passive debate is less clear-cut for bond funds than it is for active funds, the weight of the evidence on performance, combined with the especially deleterious effects of fees on naturally lower-return bond funds, combined with the behavioural benefits of passive, still results in me favouring passive bond exposure.

 

Corporate bonds vs government bonds

 

We can also filter out any corporate bond funds.

Corporate bonds provide less protection against market crashes than government bonds, often demonstrating equity-like correlations during crashes, with lower returns than equities.

Personally, I’ve never really understood the appeal of corporate bonds, and have always preferred the idea of splitting any corporate bond allocation between equities and government bonds. Like them or not, we saw from the last post that government bonds provided better crash protection, and that’s what we’re looking for here – so we can filter out any purely corporate bond funds.

 

Duration

 

We can also filter out any bond funds holding only short-term bonds, or only long-term bonds.

For those who aren’t familiar, a bond’s duration is a measure of its sensitivity to movements in interest rates. A high duration means the bond is highly sensitive to changes in interest rates (the bond’s price will go up a lot when interest rates fall, and will go down a lot when interest rates rise) and a low duration means the bond is not as sensitive to changes in interest rates.

It’s measured in years as it represents the time it takes for an investor to be repaid the bond’s price. Importantly, a bond’s duration isn’t the same as its maturity, as the duration also includes the cash received from coupons. A bond with large coupons will have a shorter duration as it repays the investor more quickly. A bond with no coupons will have a duration which is exactly the same as its time to maturity.

There’s no exact science of what constitutes short/intermediate/long-dated bond durations, but as a useful shorthand: short-dated bonds tend to have durations under 2 years, intermediate-term bonds tend to have durations of between 2 and 10 years, and long-dated bonds tend to have durations over 10 years.

Similarly, there’s no “right answer” for the correct amount of duration to take in your bond exposure, and different people have different opinions. Some people prefer short-term bonds, some prefer long-term bonds, some prefer intermediate-term bonds.

Personally, I believe intermediate-term bonds best fit with a passive investing philosophy.

As long-dated bonds have higher duration, they’re more sensitive to interest rate moves. As rates fall, long-dated bond funds will rise more than short-dated bond funds. Investors therefore hold long-dated bond funds in the hopes of falling rates.

The opposite is true of short-dated bond funds. As rates rise, short-dated bond funds fall less than long-dated bond funds. Investors therefore hold short-dated bond funds to guard against rising rates.

Bringing the two ideas together, buying a long-dated bond fund is essentially a bet on falling interest rates, and buying a short-dated bond fund is a bet on rising interest rates.

The chart below shows that future interest rate movements are as impossible to predict as stock price movements, even for the professionals whose job it is to forecast interest rates.

Interest rate predictions

And believe me, there are plenty more charts where that one came from.

If forecasting interest rate movements consistently is too difficult even for the professionals, then there’s little hope for regular investors.

The parallels here with the passive investing philosophy are obvious – interest rate movements are impossible to predict, and the market does a better job pricing future rate movements than any single investor could.

The question is then: as a passive investor, how can I avoid making a bet on interest rates?

One option is to hold both a long-term bond fund and a short-term bond fund in your portfolio. That way you partially benefit from falling rates, and are partially protected against rising rates.

Another way, and my favoured way, is to hold an intermediate-term bond fund. Rather than holding both long-term and short-term bond funds, you hold one fund which contains a selection of bonds across the duration spectrum, which, on average, have a medium-term duration. You receive the same exposure as holding both long-term and short-term bond funds, but with the added simplicity of having the exposure in a single fund.

By targeting the intermediate-term segment of the yield curve, you’re avoiding making bets on future interest rate movements, and are keeping things simple by distilling your bond exposure down to a single holding.

The simplicity of a single holding has its obvious administrative and time-saving advantages when it comes to topping up your portfolio, monitoring performance, and rebalancing. But I think more importantly it also has the added behavioural advantage of not showing the dispersion in the underlying holdings.

You’re less likely to fall prey to performance-chasing and portfolio tinkering if you can only see the performance of your intermediate-term bond fund, as opposed to being able to see the performances of both your short-term and long-term bond funds. When rates rise, the long-term bond fund will likely post large losses, and when rates fall, the short-term bond fund will likely post heavy underperformance against longer-dated bonds.

Given that negative performance causes not only worry for the investor, but also the temptation to adjust their portfolio by selling the poor performer (classic loss-aversion), holding an asset which provides middle-of-the-road performance compared to the option of holding two extremes seems preferable from a behavioural standpoint.

So now we can filter out any bond funds which target either the extreme short end of the yield curve, or the extreme long end.

 

UK bonds vs regional bonds vs global bonds

 

The next step is to think about whether we want to hold UK bonds, global bonds, or bonds issued by a specific overseas country (regional bonds). We’re taking for granted that any non-sterling bonds will have their performance hedged back to sterling (see below for why).

This is where I think the filtering will diverge in the search for our two bond funds.

For our government bond exposure, my preference would be for global government bonds, hedged back to sterling. A passive approach is supposed to be global, after all.

As it is when selecting stocks, why should we limit ourselves to the UK’s offerings, when there are plenty of other countries out there with equally strong, if not stronger, options for government bonds? Just as we don’t know whether the UK will hold the companies that will provide the strongest performance in the future, we also don’t know whether the UK government’s bonds will provide the best protection in a crash.

There are plenty of other countries with strong credit ratings whose government bonds are also likely to perform well during a crash. The UK’s credit rating was recently downgraded from AAA to AA, after all. High quality government bonds from other countries could provide diversification should UK government bonds not perform as well as we’d hoped.

And as long as foreign government bonds are hedged back to sterling and don’t add too much to the portfolio’s cost, there’s little reason to exclude them from our portfolio, just because we happen to live in the UK. As with our equity exposure, we want to avoid falling victim to home country bias.

Given the Vanguard UK Gilt ETF (VGOV) costs 0.09% (a TER of 0.07% plus 0.02% of transaction costs), and the Global Aggregate Bond ETF costs 0.12% and is hedged to sterling, there’s not much of an advantage to be had by choosing a UK gilt ETF over a global government bond fund for our government bond exposure.

However, when it comes to inflation-linked bond funds, I wouldn’t say the same.

As well as being able to provide some protection against a crash, the main advantage of holding inflation-linked bonds is to provide additional protection against unexpected inflation.

Because we live in the UK, we’re only really concerned with the UK’s level of inflation. There’s not much point holding a ‘global inflation-linked bond fund’, because we don’t really care what inflation levels are like in other countries. We’re trying to protect our portfolio against unexpected rises in prices in the UK.

So for an inflation-linked bond fund, holding local exposure over global makes more sense. For that reason, I’d favour a UK inflation-linked gilt fund.

 

Narrowing the list

 

Now our search for a government bond fund and an inflation-linked bond fund has been narrowed down considerably. We’ve ruled out active funds, corporate bond funds, and short/long term funds.

In the search for our government bond fund, we’ve also ruled out country-specific funds and are looking for global exposure.

In the search for our inflation-linked bond fund, we’re looking for UK exposure.

If we apply these filters to Vanguard’s offerings, we’re left with two candidates for a government bond fund, and a single option for an inflation-linked bond fund.

Let’s take them each in turn.

 

The search for a Vanguard global government bond fund

 

Although I said we’re left with two candidates for our government bond fund, we’re technically left with zero.

This looks like a gap in Vanguard’s offering, because they annoyingly don’t offer a global hedged government bond fund. The closest they come is the Vanguard Global Aggregate Bond UCITS ETF or, if you’re an index fund fan, the Vanguard Global Bond Index Fund. These are the two options which get closest to a global government bond fund.

The problem with both is that the Vanguard funds are aggregate bond funds – not government bond funds. That means they hold an aggregate of all global bonds issued, and while that aggregate includes government bonds, it also includes corporate bonds. The funds hold roughly 60% in government bonds (or government-related bonds), with the other 40% in corporate bonds. We want as many high-quality bonds as possible in the bond portion of our portfolio, as when equity markets fall, high-quality bonds tend to serve as better protection than lower-quality bonds.

By way of comparison, the iShares Global Government Bond UCITS ETF (IGLH) holds a selection of purely government bonds from 7 major countries around the world – the USA, Japan, France, Italy, Germany, the UK, and Canada. This fund very closely tracks the Bloomberg Barclays Global Aggregate Government Index, which was the index used in my previous post for the below chart, and is the index we’re ideally wanting our government bond fund to track:

UK investors - crash protection 4

So something like the IGLH would be perfect for our global government bond fund, but sadly it’s an iShares product, and Vanguard doesn’t offer its own version.

But how different are these two aggregate Vanguard funds to a global government bond fund? Can they be used a reasonable proxy? And how different are the Vanguard funds to each other? Does it make a difference which one we hold?

 

iShares Global Government Bond UCITS ETF (IGLH) vs Vanguard Global Aggregate Bond UCITS ETF (VAGP) vs Vanguard Global Bond Index Fund

 

Vanguard bond fund comparison v3

For the purposes of this article, the IGLH is uninvestable as it’s not on the Vanguard platform. So we’re reviewing it simply to determine whether the two Vanguard funds are reasonable substitutes.

Before we get to the comparisons, I’ll give quick explanations for the criteria we’re using, for those that aren’t familiar. Those investors who know their YTMs from their ETFs from their OCFs can skip this next section, and head straight on to the comparison.

 

ETFs vs Index Funds

 

Both ETFs and index funds aim to replicate the performance of an index. They are far more similar than they are different, and many people use the terms interchangeably. But there are a few differences between the two fund structures.

The main differences between an index fund and an ETF in general are:

  • ETFs trade like stocks, in that investors can buy and sell shares throughout the day. Index funds trade once per day, after the market closes.
  • ETFs tend to have lower minimums than index funds.
  • ETFs are usually available on more third-party investment platforms than index funds.
  • Because they tend to be traded via platforms, ETFs usually incur more costs in the form of broker commissions and bid-ask spreads than index funds (which are traded directly with the fund provider).
  • ETFs can be traded using different execution methods (like limit orders).
  • Index funds tend to be easier to make repeat investments into than ETFs (including dividend reinvestment plans).

However, when investing via the Vanguard platform, the differences between an ETF and an index fund largely fall away.

The ability to trade intra-day using an ETF is an irrelevant benefit for any investor with a long-term time horizon (which should be all of us). The minimum investment levels and reinvestment options are the same (£500 initial investment, £100 monthly direct debit). As Vanguard will be conducting the execution on your behalf, you don’t need to worry about the different execution methods. There’s also no trading commission on ETFs when using the Vanguard platform, and both ETFs and index funds are equally easy to make repeat investments into.

Whether the fund is an ETF or an index fund makes no difference when investing via the Vanguard platform.

 

Active vs Passive

 

Passive investing is the act of investing in a fund (either an index fund or an ETF) which tracks an underlying index, like the FTSE 100 or S&P 500. The fund will produce an almost identical return to the index, with the hope being that the index will provide a better long-term return than those funds trying to beat it. On the other side of the coin, active investing is investing in funds which try to beat the index. Proponents believe that the index can be beaten, and try to select funds/stocks that will outperform over the long run.

Whether you prefer active or passive is a personal choice, but regular readers of this blog will know where I sit. My arguments for favouring passive management can all be found in the ‘Active vs Passive’ section of this blog.

In summary, I’m an advocate for passive management because it:

  • Has outperformed 90%+ of active managers
  • Has lower fees
  • Is more transparent
  • Is simple and easy to understand
  • Requires no forecasting
  • Has no capacity constraints
  • Doesn’t require picking winning fund managers in advance
  • Doesn’t require deciding whether to stick with underperforming managers
  • Doesn’t incur the risk of a fund manager(s) having to suspend their fund or, worse, liquidate
  • Has much lower levels of conflicting interests
  • Becomes more powerful the more people adopt it

Although the active vs passive debate is less clear-cut for bond funds than it is for active funds, the weight of the evidence on performance, combined with the especially deleterious effects of fees on naturally lower-return bond funds, combined with the behavioural benefits of passive, still results in me favouring passive bond exposure.

 

Costs

 

For this article, I’ve used what’s known as ‘MIFID II Total Cost of Ownership’ for each fund (aka the ‘Total Annual Cost of Ownership’ or ‘TACO’).

Vanguard’s factsheets don’t display this number, but it can be found here. It differs from the traditional TER or OCF displayed on most factsheets as it also includes transaction costs for the funds, and any performance fees payable. It’s therefore a better measure of the total costs borne by the investor.

Costs are especially important when considering bond funds, as bonds have lower expected returns than equity funds. Because of this, a 1% fee will consume a higher proportion of the bond fund’s returns than an equity fund’s.

For example, let’s say an equity fund returns 5% a year and a bond fund returns 2% a year before fees, with both funds having an expense ratio of 1%. That same 1% fee means the equity fund will have its returns reduced by 20% per year (1% divided by 5%), but the bond fund will have its returns reduced by 50% (1% divided by 2%).

That’s a big chunk of returns eaten by fees. Keeping costs low is incredibly important for investors, and is a major part of why passive funds have done so well at outperforming active funds over the long term. I’ve written a longer post on the importance of fees here.

 

Yield to maturity

 

The yield to maturity (YTM) of a bond is the total return anticipated on a bond if the bond is held until it matures. It represents the returns generated from all the coupon payments, combined with the returns from any capital appreciation of the bond.

Bond funds are not quite as simple, because they hold many bonds so don’t have a single fixed maturity date. So a bond fund’s YTM is really a weighted average of the YTMs for all the bonds held in the fund.

The YTM of a bond fund is an important statistic, as it gives a good approximation of a fund’s expected returns. One of the useful aspects of bonds is that their returns are much more predictable than equities. Barring defaults, your returns will be your coupons received plus any capital appreciation on the bond.

Because of this, there’s a high correlation between a bond’s starting yield and its expected return:

Bond returns vs starting bond yieldsSource: Factor Research

We can therefore use a bond fund’s YTM as a useful proxy for its expected return.

 

Duration

 

A bond’s duration is a measure of its sensitivity to movements in interest rate. A high duration means the bond is highly sensitive to changes in interest rates (the bond’s price will go up a lot when interest rates fall, and will go down a lot when interest rates rise) and a low duration means the bond is not as sensitive to changes in interest rates.

It’s measured in years as it represents the time it takes for an investor to be repaid the bond’s price. Importantly, a bond’s duration isn’t the same as it’s maturity, as the duration also includes coupons. A bond with high coupons will have a shorter duration as it repays the investor more quickly. A bond with no coupons will have a duration which is exactly the same as it time to maturity.

 

Bond rating

 

A bond rating is a letter-based credit scoring scheme used to judge the quality and creditworthiness of a bond. Basically, the more As you can see, the less likely the bond is to default.

Investment grade bonds range from “AAA” to “BBB-” ratings (when assessed by S&P), and junk bonds have lower ratings. The higher a bond’s rating, the lower the interest rate it will carry, all else equal.

Bond ratings aren’t always correct, as we all saw in 2008 when many financial instruments rated “AAA” went into default, but they’re still the only independent assessment of a bond issuer’s ability to repay its debts.

 

Hedged vs unhedged

 

There are very few no-brainers in investing, but hedging currency exposure for bond funds is one of them.

Currencies can, and do, fluctuate significantly in the short term. Brexit is the obvious example which springs to mind – the impact of currency volatility was felt by every UK citizen whose overseas holidays became 10% more expensive overnight.

Because bonds are low risk/low return assets, large foreign exchange fluctuations can overwhelm the risk/returns offered by the bonds. Holding a safe, low yielding bond isn’t going to act like a safe, low yielding bond if it’s held in Mexican Pesos. Because it’s held in a volatile foreign currency, your bond exposure will end up looking more like you’re holding Mexican Pesos in your portfolio than safe bonds.

For that reason, to ensure the bond exposure retains its low-volatility function, hedging out the foreign currency fluctuations is sensible for most investors.

Of course, hedging can’t be done for free. But given most passive bond ETFs have expense ratios under 0.30%, the price paid for hedging is not particularly high, especially when compared against the diversification and risk-reduction benefits it provides.

 

Accumulation vs income share classes

 

Income share class automatically pay out income, and accumulation share classes automatically reinvest income. The difference is as simple as that.

It’s worth noting that this doesn’t make a difference for tax purposes. Even if income is automatically reinvested via an accumulation share class, it’s still treated as reportable income as far as the taxman is concerned, and should be reported on your tax return accordingly. Obviously if you’re holding the funds in a tax wrapper, then you don’t need to worry about it.

The main advantage of accumulation share classes over income share classes is that you don’t need to bother with manually reinvesting the dividends. Holding income share classes means cash will build up in your account after each distribution is made by the fund, and you’ll need to go in and choose to reinvest it. Some platforms will charge you for setting up an automatic dividend reinvestment plan, but as far as I can tell Vanguard doesn’t offer this option anyway.

Accumulation share classes simply save you a minor hassle.

 

Structure and replication method

 

A physically replicated index tracking fund means the fund buys the underlying stocks in an index. For example, a physical ETF tracking the FTSE 100 would buy each of the 100 stocks in the FTSE 100 in line with their weightings. This is in contrast to a synthetic ETF which uses derivatives (usually swaps) to mimic the performance of an index without actually buying any of the index’s underlying stocks.

When tracking an index, physically replicated funds have the option to either buy all the stocks in an index – known as ‘full replication’, or buy a large enough sample of the stocks so that the performance is close enough – known as ‘sampling’. Sampling means funds don’t have to buy every single stock in an index, which minimises trading costs to the investor. It’s especially useful in markets where trading costs are higher due to illiquidity (such as in emerging markets).

Most global equity and bond funds involve a degree of sampling, which is to be expected when buying global funds. Nobody can expect a fund to buy every single stock or bond in the world.

 

UCITS compliance

 

UCITS is a regulatory framework which sets minimum standards for risk and fund management. These include holding a diversified portfolio, publishing clear guidance on their charges, and taking steps to safeguard investors’ money.

UCITS products are not necessarily safer, nor are non-UCITS products necessarily riskier, but if a product is not UCITS compliant then it may mean you need to conduct additional due diligence into the fund’s operations.

 

UK reporting status

 

First things first. I am NOT a tax adviser, tax expert, tax specialist, or any other form of authority on tax. None of this should be read as being advice, and you should always consult a professional tax adviser if you think this could impact your tax situation.

With that out of the way, we can now take a brief foray into the world of offshore funds.

UK domiciled funds are treated under standard UK tax rules (all income – whether distributed or accumulated is taxed as dividend income, gains at sale are taxed under capital gains). Offshore funds are treated slightly differently for tax purposes.

For those holding funds inside a tax wrapper, whether a fund is onshore or offshore makes no difference. However, for those investors holding them outside a tax wrapper, it’s worth noting whether offshore funds have UK reporting status.

UK Reporting Fund status is a regime to combat perceived tax avoidance by UK investors investing in offshore funds.

UK individual investors in offshore funds are taxable on their investment gains at rates of either 20% or 45%. The lower tax rate is only available to individual investors in funds with UK reporting status.

A UK investor in a non-reporting fund must pay income tax on their realised gain at rates of up to 45%. However, in the case of a reporting fund, the gain on realisation is treated as a capital gain, taxable at a maximum rate of 20%.

The purpose of imposing income tax rates is to prevent UK investors accumulating income free of tax in an offshore fund, and then claiming capital gains tax treatment when they sell the fund.

If the offshore funds regime didn’t exist, UK investors could accumulate income offshore indefinitely and convert the income into capital when the funds are sold. The UK reporting status regime puts certain requirements in place for offshore funds and if they’re fulfilled, the investor will benefit from capital gains tax treatment at sale.

Essentially, offshore funds with UK reporting status are treated the same way as onshore funds for tax purposes. That’s great if you’re investing from outside a tax wrapper – it means you won’t get slapped with a huge 45% tax bill when you sell.

 

Securities lending

 

ETFs are able to generate revenue by lending out the securities they hold. The borrowers of the securities are usually short sellers, and pay a fee for being able to borrow the ETF’s stocks. The fee generated from lending is usually shared in some proportion between the ETF and the fund manager. The percentage of the securities lending revenue (SLR) which is returned to the ETF increases the fund’s returns, and the percentage of the revenue returned to the fund manager increases the manager’s profits, but isn’t a direct benefit to investors.

Lending does come with drawbacks, primarily the risk that the borrower isn’t able to return the stock (default risk). The higher the percentage of NAV lent out through securities lending, the higher the default risk.

Thankfully for those concerned about default risk, Vanguard is traditionally on the conservative end of securities lending.

Now that we’ve got our learning out of the way, we can start figuring out whether the two Vanguard bond fund options are reasonable substitutes for a global government bond fund.

 

iShares Global Government Bond UCITS ETF (IGLH) vs Vanguard Global Aggregate Bond UCITS ETF (VAGP) vs Vanguard Global Bond Index Fund

 

To save you some scrolling, I’ve reposted the comparison table here:

Vanguard bond fund comparison v3

From looking at the table, IGLH is very similar to the Vanguard funds. The main differences are that the global government bond fund has a slightly lower yield to maturity (0.27% vs 0.80%), a longer duration (8.83 years vs 7.5 years), and slightly more in AAA rated bonds (52% vs 41%).

All these differences make sense, as IGLH holds more higher-credit rating, lower yielding government bonds, compared to the Vanguard funds which hold more higher-yielding corporate bonds.

With such similar characteristics, we’d expect performance to be broadly similar. So let’s have a look.

 

Performance comparison

 

Comparing all three funds is annoyingly hampered by their lack of track record, as they only have performance history going back to June 2019. However, even with this limited data, we can already see the 2 Vanguard funds are very similar, while IGLH provides slightly different performance. The performance difference is especially pronounced during the coronavirus crisis in Q1 2020:

Bond fund performance chart 1Source: Bloomberg

Zero-ing in on the coronavirus crash, equity markets (measured by the MSCI World) fell 26% between 19th February and 23rd March 2020. So how did our government bond fund compare to Vanguard’s options during the market drawdown?

Bond fund performance chart 2Source: Bloomberg

The government bond fund provided more protection than our Vanguard funds, managing to post a gain over the period. Although not quite making it into positive territory, the Vanguard funds still fell far less than the market – falling only 3% compared to the market’s 26% fall. Compared to a 26% drawdown, though, both our funds provided strong protection.

Now let’s look longer-term to see if we can find any differences in performance. For that, we’ll have to rely on the performance of the underlying benchmarks for the funds, as the indices have longer track record than the funds themselves. Both Vanguard funds use the same benchmark, which makes life a little simpler:

Bond fund performance chart 3Source: Bloomberg

Annoyingly, the global aggregate index used for the Vanguard funds still has less than 2 years of performance data. Luckily there’s another index which has the same performance…

Bond fund performance chart 4Source: Bloomberg

… But has a longer track record, dating back to 2009:

Bond fund performance chart 5Source: Bloomberg

Sadly the index doesn’t have data for 2008, but we can at least see that in the recent bond bull market, the global aggregate (the benchmark for our Vanguard funds) has slightly outperformed the global government bond index. This is what we’d expect to see, given the larger exposure to corporate bonds in the global aggregate, coupled with the slow march downwards in interest rates which has rewarded any extra credit risk.

Overall, it looks like the Vanguard funds are likely to perform slightly better than a global government bond fund over the long-term given their lower average credit-ratings, but will provide slightly less protection in a crash.

However, the differences are minor, and likely not going to be large enough to make or break an investor’s portfolio.

Not that we have a choice if we’re investing on Vanguard’s platform, but the two Vanguard aggregate funds look like reasonable substitutes for a global government bond fund.

Now the question becomes: how different are these two Vanguard funds to each other? Does it make a difference which one you hold?

 

Vanguard Global Aggregate Bond UCITS ETF (VAGP) vs Vanguard Global Bond Index Fund

 

With that in mind, we can now turn our attention to choosing between the two Vanguard funds. Let’s compare the similarities and differences:

Similarities

  • Fund type. The fact that the Vanguard Global Aggregate Bond UCITS ETF is an ETF and the Vanguard Global Bond Index Fund is an index fund doesn’t make a great deal of difference. When investing via the Vanguard platform, almost all differences between the ETF and the index fund disappear.
  • Management style. Both are passive funds, tracking the global bond market.
  • Cost. Vanguard Global Bond Index Fund costs 0.29% per year, compared to VAGP at 0.26% per year. Although the TER of the index fund is 0.15%, according to the company’s disclosure on MIFID II costs and charges, the fund incurs a further 0.14% in transaction costs. VAGP has a TER of 0.10%, and transaction costs of a further 0.16%. (A link to the disclosure is here, for those interested.) It’s true that VAGP is 0.03% cheaper to hold, but I don’t think that’s a large enough difference to choose one fund over another. A 3 basis point difference in fund cost isn’t ever going to make or break a portfolio.
  • YTM, duration, and credit quality. Both have almost identical yield-to-maturities (YTMs), duration, and credit quality.
  • Benchmarks and performance. Both have exactly the same benchmark, hence the almost identical performance.
  • Currency exposure. Both are hedged back to sterling.
  • Structure and replication method. Both funds use physical replication with sampling.
  • Size. Size doesn’t matter so much for ETFs, but given that both funds are over £1bn they’re definitely large enough.
  • Regulatory status. Both funds are UCITS compliant. They are also both offshore funds, but have UK reporting status, so are taxed in a similar manner to regular onshore funds, if held outside a tax wrapper.
  • Securities lending. Neither fund lends out its bonds.

Differences

  • Share classes. The index fund offers both accumulation and income share classes, whereas VAGP only offers income, and pays income monthly.

 

Conclusion – best Vanguard global government bond fund

 

The two Vanguard bond funds we’ve compared here are far more similar than they are different. The differences are so minor that either one is an excellent choice.

For the hands-off investor who doesn’t want to worry about reinvesting income, the index fund does have a slight advantage here, by offering an accumulation share class which the ETF doesn’t – but this is the only real difference between the two.

Now we’ve compared the various government(ish) bond funds, we still need to find an inflation-linked bond fund.

 

The search for a Vanguard inflation-linked bond fund

 

This should be quick, as Vanguard only offer one inflation-linked bond fund on their platform – the Vanguard UK Inflation-Linked Gilt Index Fund.

Although passive investors favour global exposure in their equities and government bonds, having UK-based inflation-linked bonds does seem to make more sense. The UK’s inflation linked bonds are tied to the inflation rate in the UK, which is where we’re all spending our cash. So it makes less sense to hold global inflation-linked bonds, as we only care about the inflation rate in the UK.

Looking at the fund, the Vanguard UK Inflation-Linked Gilt Index Fund comes with a lovely -2.5% YTM and a whopping 21.8 years average duration. Although the yield looks bad, it isn’t as horrific as it sounds. It is, however, pricing in a relatively high level of inflation, and will only outperform nominal bonds if inflation rises above 3.3% (YTM of 20 year nominal bond of 0.8% minus YTM of inflation-linked bond at -2.5% equals 3.3%).

The long duration of the fund isn’t ideal either, for the reasons discussed above.

The rationale for holding inflation-linked bonds (and why they have lower yields than nominal bonds) will be covered in a later article, as it requires more discussion that I have room for here. The short answer is, though, that they offer the opportunity for some downside protection, while also protecting against unexpected inflation. The key word there is unexpected. Current inflation expectations are already baked into the fund’s price. Protecting against unexpected things, though, should be one of the major functions of any portfolio – especially passive investing, given it’s the ultimate “I know nothing” approach. As a result, I think inflation-linked bonds fit well within a passive portfolio, and as a passive investor myself, I have a natural preference for index-linked bonds.

The benchmark the fund tracks is the same benchmark used to create the chart below (which featured in my previous post). So it has done well at protecting against crashes in the past, although its ability to do the same going forward is subject to the same caveats mentioned in the previous article.

UK investors - crash protection 3

Would I invest in it? Although it seems to offer poor value versus nominal bonds given the breakeven inflation rate of over 3%, and it’s also taking on plenty of duration risk, I still think I’d be a buyer. It may not be as attractive right now, but we’re constructing a portfolio meant to last an investing lifetime. With that in mind, I’m quite happy with it as a long-term allocation in my portfolio.

Luckily for me, I’m in an all-equity portfolio, so don’t have to make this decision. However, if I were having to find something to diversify my equities, my approach would be to diversify my diversifiers.

Owning a combination of nominal intermediate-term hedged government bonds, inflation-linked bonds, cash, and gold (although I’m still undecided on gold, see here for why) would provide a solid set of options to protect the equity portion of a portfolio. All are cheap, liquid, transparent, and easily accessible.

Inflation-linked bonds provide another source of protection in an equity market crash, while providing some level of protection against unexpected inflation.

 

Conclusion

 

Sadly there’s no silver bullet when it comes to crash protection.

I don’t think it’s safe to assume bonds will provide the same level of protection as in the past (see here), so the default option of only holding bonds as a diversifier seems riskier now today than previously.

I have no idea which diversifier will prove to be the best crash protection going forwards, but that’s the benefit of diversifying your diversifiers. I’ll never be only invested in the best diversifier, but I’ll never be only invested in the worst, either.

I wrote extensively in this post (Smooth is what we aim for) about how important it is to aim for smooth returns. And that’s exactly what a diversified approach to diversifiers does.

Given the function of crash protection is to provide an emotional hedge against reactive behaviour during stock market volatility, I’m more confident that a basket of diversifiers will help to achieve that than by betting the house on any single choice.

As a result, I believe both a global government bond fund and a UK inflation linked index fund have a place in portfolios.

Although Vanguard doesn’t offer a global government bond fund, its two global aggregate bond funds come pretty close. Of the two offered, the only noticeable difference is the ability to own an accumulation share class. Otherwise they’re practically identical.

For those wanting to hold index-linked bond funds, then Vanguard also has you covered – but you only have one option. Love it or hate it, the Vanguard Inflation Linked Index Fund is the only one for you.

It’s also worth reiterating the point I made at the end of my article on the best Vanguard equity funds for UK investors:

As you’re now deciding on precisely which vehicle you’re going to use to achieve your low-cost, transparent, liquid, diversified bond exposure, you’ve already won the investing game.

Once you’ve made it to this point, other factors, such as your spending habits, earnings potential, housing decisions, children, and choice of spouse will have a far larger impact on your eventual portfolio size than choosing between any of these funds.

The most important thing, now you’ve made it here, is to make a decision you’ll be able to stick with, and devote your time and energy to other, higher impact areas.

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James
3 months ago

Thanks for a great article. Interesting view that for linkers you pick only UK exposure, whilst there is logic in hedging against UK domestic inflation, the very large duration of UK linker funds means you are exposed to very large interest rate risk and so these are unlikely to be a very good hedge against inflation. Perhaps a global inflation linked bond fund hedged to GBP would be better? It would be great to hear your analysis of this. See this Monevator article for more: https://monevator.com/why-uk-inflation-linked-funds-may-not-protect-you-against-inflation/

Rich
3 months ago

Looking forward to your post regarding inflation-linked bonds, currently weighing up including them myself.

I would have thought having international cap weighted equity and bond funds would be a pretty effective inflation hedge in its own right when only 5% of the holdings are within the UK though?

Mr Finlay McNicol
5 months ago

This article is precisely what I was looking for! many thanks, you have saved me many hours if not days of trying to untangle this myself, brilliant!

Mike
5 months ago

A very useful article, thanks Occam. I’ve been waiting for this since the great Vanguard Passive Funds article you wrote and have since invested in the VWRL.

With Bonds, I was also looking to protect my portfolio as you suggest and I wanted to do this whilst remaining a passive investor. I was following the FIRE movement and specifically the Quit Like A Millionaire book by the Millenial Revolution blog owners. This suggests passive investing but then suggests having a portfolio split at a ratio based on your age e.g. a 30 year old would have a portfolio of 70% Equities and 30% Bonds. I’m interested to hear more about your reasons for holding an 100% Equities portfolio though. I think I will also stick with 100% Equities as the portfolios I hold are long term investments; one is for my son’s future and he’s only 3 months old now 🙂 and one is for my retirement in 30+ years. So I think I can wait to consider any portfolio protection and a less risk strategy closer to when I want to draw down from these. Do you agree?

I’ve also dropped a comment on the Passive Funds article asking whether you’re willing to share details of the hedged and unhedged index trackers you’re currently invested in and which platform you’re using?

Many thanks,
Mike

Neil
5 months ago

I think VAGS is the accumulation version of VAGP.

Rob
5 months ago

Thank you for a fantastic analysis of the best Vanguard bond funds currently on offer. I still believe good credit rated bonds retain their place as a portfolio diversifier to equities if that’s what you’re looking for. OK they might not offer the previous levels of income but nonetheless they should still hold up better in any downturn.

As I’m still in the accumulation phase I’m 100% passive global equity in my workplace pension. However, I’m not quite there for a 100% equity holding in my Vanguard SIPP and it’s probably more behavioural than risk. For a while I’ve held 15% cash alongside my 85% global equity tracker. With hindsight this was kind of pointless and was (shock horror) a veiled attempt at market timing as I won’t be touching this SIPP for 15 years+.

So on Monday I invested in the Global Short-Term Bond Fund as my bond fund / cash proxy. 52% of the bonds are 1-3 years in duration and 44% are 3 to 5 years (the remainder 5yrs). Very similar credit rating across the bonds as the Global Bond Fund (80% between AAA and A). My primary aim was to have a low volatility fund. This fund fell much less than the Global Bond Fund in March (and clearly has risen much less since). Who knows what the future holds!

I will never sell my equity holdings. But if we get a large drop I might get my day in the sun for a little market timing…. It’s like living with Gollum inside my head at times….

Nick
5 months ago

Another insightful post.
Thank you for your efforts, very helpful for the DIY investor.
Have a great Christmas and new year.