Total market bond funds offer competitive yields, but do they belong in your portfolio?
Often complex and misunderstood, these funds encompass more than basic bond investments; they vary in structure, management approaches and risk characteristics.
Active management in the bond market presents unique challenges, as managers must carefully navigate duration and credit exposures to outperform benchmarks, often by adjusting duration or targeting higher-yield corporate bonds.
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If you’re thinking of working with an adviser to include total market bond funds in your portfolio, here’s what you should know.
What are total market bond funds composed of?
Total market bond funds were traditionally used to reduce equity risk and enhance diversification and are composed of various public and private bonds.
For example, the Bloomberg U.S. Aggregate Bond Index (the Agg), which tracks more than 10,000 securities with a total value of roughly $50 trillion+, is made up of three primary components: U.S. Treasuries, corporate bonds and mortgage-backed securities.
Overarchingly, with total market bond index funds, the more debt an entity issues, the greater its weight in the index. Hence why U.S. Treasuries are such a large component of the index.
Besides the Agg, what are other common total bond market funds?
Many funds track an Agg-like index. Some are actively managing “total bond” or “core/core-plus” funds. They mostly use investment-grade U.S. bonds, including Treasuries, agencies and investment-grade corporate bonds, as well as agency mortgage-backed securities.
Active “total bond/core /core-plus” funds offer more flexibility. They include more corporate, securitized and mortgage assets. Some funds add high-yield and international bonds.
How should investors assess their risk appetite?
To accurately gauge risk tolerance with total market bond funds, investors must identify interest rate, credit and duration risks. While diversification is often viewed positively, it may not always yield stability in bond portfolios.
Previous beliefs about bond reliability must be reevaluated. For example, while interest rates are higher than they were before 2022, can bonds earn enough income to offset inflation moving forward?
When interest rates rise, the value of existing bonds declines. Funds linked to the Agg generally have significant duration, which increases their sensitivity to rate fluctuations. A prolonged period can lead to significant losses during rising interest rates.
Between 2021 and 2022, investors encountered substantial losses in perceived “safe” bond funds as rates surged. Confusing duration with maturity and misjudging rate sensitivity contributed to negative surprises. Not all advisers may be up to the task.
How should investors benchmark a total market bond fund’s performance?
Benchmarking is crucial for managing total bond market funds and is highly personalized.
To see if a bond fund works for your specific financial goals, you or your adviser should compare it to the Agg over time.
Many investors compare their portfolios to the S&P 500, even in a 60/40 or 40/60 mix. Old rules, like “age in bonds,” are archaic and come from a time of high rates that no longer exist.
To try to beat the Agg, active managers might buy more investment-grade corporates rather than Treasuries, then add high-yield or unrated bonds and invest in securitized credit, such as mortgage-backed securities.
This approach may increase yields but can also heighten vulnerability to economic contraction and credit disruptions, potentially leading to pronounced losses during severe credit downturns.
Your personal risk appetite will determine whether total market bond funds is a good strategy.
Ultimately, investors should prioritize achieving personal financial objectives and treat total bond market funds as portfolio instruments rather than inherently “safe” investments.
Remember that two total bond funds with similar names may have very different risk levels.
To strategically add them to an otherwise healthy portfolio, carefully assess duration, credit composition, sector allocation, fees and performance relative to the Agg before moving forward.
Working with a knowledgeable adviser can mean the difference between injecting a healthy dose of risk, aiming for a smart long-term gain or demolishing the portfolio you’ve worked hard to build.
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