The Best Bond Funds All Have One Thing In Common

Let’s face it:  stocks get all the attention.   And I guess that makes a certain amount of sense, since rarely will you see a bond fund return 30+% one year and lose 15% the next like stock funds all-too-often do.  But seeing as how bonds will make up an increasingly-substantial percentage of your asset allocation as you near retirement, I’d say it’s at least as vital to make sure you’re getting the most out of your bond portfolio as getting the most from your stock portfolio.

What Do The Best Bond Funds Have In Common?

It is a truism in the investment world that past performance is no indication of future results.  Top mutual funds from one period often become the worst-performing funds in the next.  So common is this phenomenon that mutual fund companies are required by law to print it as a warning on every mutual fund prospectus.  Since nobody can predict future stock returns, nobody can predict which funds will out-perform the market (or its peer mutual funds) going forward.  Hence, it is prudent for investors to focus on what they can control, investment costs, rather than what they cannot (future stock returns).

With bonds, costs are even more important.  Since bonds in general yield lower returns than stocks, the drag of high costs are even more damaging.  A 1% expense ratio on a bond fund will cut into long-term returns even more than a 1%  expense ratio on a stock fund because the bond fund’s long-term returns are likely to be lower.  Thus, the number one thing all the best bond mutual funds have in common is low costs, which means you can safely limit your search to identifying the best bond index funds.

What’s A Good Expense Ratio For A Bond Fund?

The above advice begs the question:  what’s a good expense ratio, anyway?  The Vanguard Total Bond Market Index Fund (VBMFX) sports a stingy expense ratio of 0.22%, which is what I would use to measure every other bond fund against.  If you can own every high-grade bond, both corporate and government, for only 0.22% per year, why would you pay more?

Unfortunately, many people do all their investing through a 401k plan and most 401k plans are notoriously bad.  In that case, you may have no choice but to buy the lowest-cost bond fund in the plan, which may or may not align well with your investment objectives.  Alternatively, if you also have an IRA at a low-cost provider like Vanguard, you can arrange to own the majority of your bonds in your IRA and buy low-cost stock funds in your 401k, which typically contain at least one stock index fund.