Bogleheads® on Investing Podcast 045: Nick Gendron, Josh Barrickman on Total Bond Market Index Funds

00:00:00.000 | [MUSIC PLAYING]

00:00:10.420 | Welcome, everyone, to Bogle Heads

00:00:11.840 | on Investing, episode number 45.

00:00:14.600 | Today, our discussion is on the Total Bond Market Index Fund.

00:00:19.400 | And we have two special guests, Nick Gendron,

00:00:22.360 | Global Head of Fixed Income Index Product Management

00:00:25.160 | at Bloomberg, and Josh Barrackman, Principal

00:00:28.760 | and Head of Fixed Income Index Investing at Vanguard.

00:00:32.220 | [MUSIC PLAYING]

00:00:42.640 | Hi, everyone.

00:00:43.320 | My name is Rick Ferry, and I'm the host

00:00:45.000 | of Bogle Heads on Investing.

00:00:46.960 | This episode, as with all episodes,

00:00:49.280 | is brought to you by the John C. Bogle Center

00:00:51.560 | for Financial Literacy, a 501(c)(3) nonprofit organization

00:00:56.640 | that you can find at boglecenter.net.

00:01:00.760 | Now, before we get started with this episode,

00:01:02.680 | I have a public announcement.

00:01:04.480 | Tickets for the Bogle Heads conference have gone on sale.

00:01:09.120 | You can find information on boglecenter.net and bogleheads.org.

00:01:14.840 | The conference will take place in a suburb of Chicago

00:01:17.920 | on October 12 through the 14th.

00:01:20.200 | It is a non-commercial conference.

00:01:22.300 | There are no sponsors.

00:01:24.160 | There is no commercialism.

00:01:25.960 | No one is going to try to sell you anything.

00:01:28.320 | It's pure investment education.

00:01:31.300 | I'm looking forward to seeing you there.

00:01:33.800 | In this 45th episode of Bogle Heads on Investing,

00:01:36.860 | we're discussing total bond market investing, also called

00:01:41.000 | aggregate bond market investing.

00:01:43.440 | And I have two special guests.

00:01:45.160 | My first guest is Nick Gendron.

00:01:47.600 | He is the Global Head of Fixed Income Index Product Management

00:01:52.160 | at Bloomberg.

00:01:53.240 | Nick's team creates the Bloomberg Aggregate Bond Market

00:01:57.280 | Index, which is the index that total bond market index

00:02:00.880 | bonds follow.

00:02:02.120 | The next guest is Josh Barrichman.

00:02:04.840 | He is Principal and Head of Fixed Income Indexing

00:02:08.280 | at Vanguard.

00:02:09.600 | Josh's team are portfolio managers.

00:02:12.320 | They take the index that Bloomberg puts together,

00:02:15.800 | and they have to create a real live working portfolio out

00:02:19.160 | of it.

00:02:19.760 | And that's quite a challenge.

00:02:21.080 | We're going to start first with Nick,

00:02:23.000 | and then we're going to move on to Josh.

00:02:26.880 | So with no further ado, let me introduce Nick Gendron.

00:02:31.200 | Welcome to the Bogle Heads on Investing podcast, Nick.

00:02:34.320 | Thank you very much, Rick.

00:02:35.480 | Appreciate it, and really happy to be here with you.

00:02:38.520 | Well, thanks.

00:02:39.320 | You are the first guest on our podcast today.

00:02:42.840 | And your job is to create the fixed income indexes that

00:02:49.440 | are used for index fund tracking.

00:02:52.560 | Before we get moving here and talking about total market

00:02:57.080 | index or the aggregate bond market index, which

00:02:59.120 | is going to be our main focus today,

00:03:01.080 | tell us a little bit about your background

00:03:02.840 | and how you got to be the head of Fixed Income Index Product

00:03:07.320 | Management for Bloomberg.

00:03:09.460 | Yeah, sure, I'm happy to share that.

00:03:12.160 | I actually joined Lehman Brothers a few years

00:03:15.480 | after I got out of college.

00:03:17.280 | I was going for my MBA back then,

00:03:19.440 | and they were really looking for people

00:03:21.600 | to come in and help them as they were starting to really build

00:03:25.920 | an index business, just come in and help with client support

00:03:30.600 | around indices.

00:03:31.480 | They were starting to get a lot of questions

00:03:33.400 | around what they were doing, and Lehman Brothers was certainly

00:03:36.060 | a big bond shop.

00:03:36.800 | So it made sense that they were producing

00:03:40.080 | these types of indices to share with the marketplace.

00:03:43.240 | But I really came in in more of a client support role.

00:03:46.560 | Didn't know much about bonds at the time,

00:03:48.480 | but was looking for a change of career,

00:03:50.120 | and they gave that to me.

00:03:51.760 | And the rest was history.

00:03:53.440 | I just kind of kept moving through the system.

00:03:56.760 | We did a lot of portfolio strategy work for clients

00:03:59.320 | with our indices, et cetera.

00:04:01.080 | And we learned all sorts of risk analytics

00:04:04.300 | and provided those to the marketplace as well,

00:04:07.280 | and ultimately evolved into Barclays

00:04:09.800 | once Lehman went under in 2008.

00:04:13.040 | And then Bloomberg bought our franchise from Barclays

00:04:17.160 | in August of 2016.

00:04:19.160 | So I've been at Bloomberg for about the past

00:04:21.880 | five and a half years.

00:04:23.680 | - So if I hold that up, you have been involved

00:04:26.800 | in fixed income indexing for 30 years

00:04:30.680 | as of next month, correct?

00:04:33.200 | - That is correct.

00:04:34.120 | We're coming right up on the 30 year anniversary,

00:04:36.280 | which is really hard to believe,

00:04:37.560 | but it's definitely been an exciting run,

00:04:41.080 | and it's kept me in the business

00:04:42.480 | because the business just keeps changing

00:04:44.920 | and the needs of investors keep changing.

00:04:46.880 | And it's definitely not a rinse and repeat type industry.

00:04:51.800 | There's always innovation needed

00:04:54.320 | and lots of interesting client conversations to have.

00:04:58.080 | - Now originally when you went to Lehman Brothers,

00:05:00.680 | the number of index funds out there were fairly limited.

00:05:05.200 | - Yeah.

00:05:06.040 | - So the purpose of the indices that you were running

00:05:10.200 | were more for benchmarking.

00:05:12.840 | So can you describe the difference between indexes

00:05:16.680 | for a benchmark versus index for an investable product?

00:05:21.680 | - Many clients use our indices

00:05:24.560 | for what we call just benchmarking.

00:05:27.120 | And for just standard benchmarking,

00:05:29.520 | clients, they really need a home base

00:05:32.480 | or a foundation from which to make investment decisions.

00:05:36.880 | If they use the US Ag, for instance, as a benchmark,

00:05:41.880 | that's what is considered market neutral.

00:05:45.240 | So for them to prove

00:05:46.880 | that they can use their investment prowess, if you will,

00:05:50.280 | to add value, that's a great place to compare yourself to.

00:05:55.280 | If the US Ag is truly meant

00:05:58.200 | to be a market neutral representation of the universe,

00:06:03.200 | we do have many clients that just use that

00:06:05.800 | to compare themselves to and manage their risk

00:06:08.520 | to that benchmark each day

00:06:09.960 | while hopefully showing out performance.

00:06:13.560 | From a passive side of things,

00:06:16.120 | certainly most ETFs, if you will,

00:06:18.360 | and many mutual funds and many institutional funds

00:06:22.120 | really try to track the index exactly

00:06:25.560 | by the basis point almost in fixed income.

00:06:28.320 | So it really is a difference between passive versus active.

00:06:33.320 | - It's interesting that a lot of the index fund managers

00:06:39.240 | use the term total bond market

00:06:42.280 | for the US aggregate bond market index.

00:06:45.720 | And Barclays doesn't use that term, total bond market,

00:06:50.000 | because it's not the total bond market.

00:06:52.480 | So could you explain what is the US aggregate bond market?

00:06:57.480 | - Yeah, I mean, in some ways, Rick,

00:07:01.040 | it's intended to be the total of some bond market,

00:07:05.080 | but the question is what bond market is it supposed to be?

00:07:08.680 | And in the case of the US aggregate,

00:07:11.840 | it's really designed to be a representation

00:07:15.080 | of what I would call the core investment grade

00:07:19.800 | US dollar denominated.

00:07:21.920 | So if you're in the US, any US dollar bond,

00:07:25.360 | but again, the key thing is core investment grade

00:07:29.640 | US dollar denominated.

00:07:31.640 | And then we have to give it a name, right?

00:07:33.280 | And US AG has been sort of the trademark name

00:07:36.280 | for a long time, and it's become a flagship name

00:07:39.000 | in the industry.

00:07:40.000 | Again, we could have at some point in time,

00:07:41.880 | way back when decided, hey, we're gonna call this

00:07:44.120 | the total bond market index, but we decided,

00:07:46.680 | nope, US AG is a better name.

00:07:48.800 | And again, total bond market to me would be

00:07:51.480 | every bond out there, it could be any asset class,

00:07:54.720 | it could be any currency denomination, et cetera.

00:07:58.280 | So again, it really depends on the market

00:08:00.800 | that you're talking about.

00:08:02.960 | - That's interesting because it really,

00:08:04.840 | there's a lot of types of bonds, US bonds,

00:08:09.240 | that are not in the US aggregate index,

00:08:14.240 | which is the basis for total bond market index funds.

00:08:18.520 | The one that jumps out is TIPS,

00:08:20.800 | Treasury Inflation Protected Securities.

00:08:23.400 | Gosh, I mean, this seems to be such a natural fit

00:08:26.160 | for a total bond market index fund,

00:08:28.600 | but it's not in the aggregate index.

00:08:31.240 | So why don't you start with that

00:08:32.800 | and kind of go down the list?

00:08:34.360 | - You've prompted a very interesting dynamic

00:08:36.600 | when TIPS started to be issued in 1997.

00:08:40.440 | And the reason I remember that exact date

00:08:44.960 | is just because that was actually the birth,

00:08:48.320 | if you will, of what we call our index advisory councils,

00:08:52.160 | which became more formal meetings

00:08:54.120 | with our major index users to get feedback

00:08:57.640 | on how we evolved the methodology within our indices.

00:09:01.160 | But TIPS was a huge debate back then.

00:09:04.640 | Our inclination when TIPS were issued

00:09:07.080 | was to put them in the US Act.

00:09:08.920 | There were many investors and many that disagreed

00:09:13.200 | with that sentiment that inflation itself

00:09:16.800 | really should be a separate asset class

00:09:19.640 | and doesn't belong in the true spirit

00:09:22.120 | of a traditional fixed income investment.

00:09:26.360 | So there was a debate.

00:09:27.760 | And if you went around the industry today,

00:09:29.720 | you'd still probably get several investors

00:09:32.640 | who would think that TIPS should be part of the US Act.

00:09:35.880 | But that's some of the interesting part

00:09:38.760 | of being an index provider

00:09:40.840 | is investors don't always agree on everything.

00:09:44.120 | The bond market has a lot of different factors,

00:09:47.000 | a lot of different types of securities that are out there.

00:09:50.120 | And we have to work to try to synthesize

00:09:55.000 | all of that feedback, if you will,

00:09:56.640 | into what we feel should be in the US Act.

00:09:59.520 | So there was actually a real good debate about it.

00:10:01.960 | And it's something that we've brought up over the years

00:10:05.160 | with our index councils.

00:10:07.200 | 1997 wasn't the only time.

00:10:09.520 | But still as of today, TIPS are not part of the benchmark.

00:10:14.040 | - And this is an investment grade index,

00:10:17.480 | so there's no high yield.

00:10:19.760 | - No high yield.

00:10:20.640 | Completely separate high yield index.

00:10:23.120 | And the definition of ag for us is investment grade

00:10:27.800 | is one of the keys.

00:10:29.600 | We have what's called a global ag too,

00:10:31.400 | which spans 28 currencies, but it's all investment grade.

00:10:35.360 | So again, separate indices for high yield

00:10:38.960 | for emerging markets, municipals, inflation, et cetera.

00:10:43.800 | The ag part of it, the investment grade part

00:10:46.080 | of the bond market is by far the largest component.

00:10:49.040 | - And ironically, something that is in the index,

00:10:51.360 | which a lot of people don't know,

00:10:54.520 | are what are called Yankee bonds,

00:10:56.800 | which are foreign bonds.

00:10:58.840 | - Yep.

00:10:59.680 | Yankee bonds are an interesting dynamic.

00:11:02.280 | There are a lot of non-US institutions

00:11:06.800 | or government bodies, what have you,

00:11:10.880 | that issue US dollar denominated securities.

00:11:14.960 | So just a little research on this,

00:11:17.080 | there's actually in the US ag,

00:11:19.280 | there's 1,400 securities that are Yankee bonds.

00:11:23.520 | - Wow.

00:11:24.480 | - Almost 2 trillion of the index is in Yankee bonds.

00:11:27.400 | So you say, okay, well, who are those issuers?

00:11:30.960 | Many of them are these supranational institutions,

00:11:34.200 | IBRD, which is International Bank

00:11:36.440 | of Reconstruction and Development, EIB,

00:11:39.400 | European Investment Bank, ADB, Asia Development Bank.

00:11:43.120 | So there's these supranationals that issue a lot of debt

00:11:46.600 | and most of it is in US dollars.

00:11:49.640 | So those go in the US ag, they're investment grade debt,

00:11:52.240 | but yeah, they're non, governments like Mexico,

00:11:57.000 | Peru, Philippines, all issue investment grade debt

00:12:01.680 | in US dollars, that's in the US ag.

00:12:04.160 | It's an interesting component of the market.

00:12:06.280 | Canadian provinces issue US dollar denominated debt.

00:12:10.240 | So those are some examples of Yankee bonds.

00:12:13.080 | There's certainly other government bodies

00:12:14.880 | that issue US dollar denominated bonds as well

00:12:18.000 | that are what are called 144As,

00:12:21.120 | or they're not SEC registered bonds.

00:12:24.360 | And that's another rule of the US ag.

00:12:26.360 | They have to be SEC registered.

00:12:28.200 | So Saudi or Indonesia,

00:12:32.080 | they issue US dollar denominated debt as well,

00:12:35.040 | but it is in 144A form.

00:12:38.000 | So that does not go into the US aggregate index.

00:12:41.840 | These are just some of the rules

00:12:43.480 | that have been in place for a while

00:12:45.640 | and we revisit them every so often,

00:12:47.840 | but that's how we stand today.

00:12:50.400 | - What would you say the percentage

00:12:51.920 | of the US aggregate index is in Yankee bonds?

00:12:56.800 | - So I guess it's just a matter of the math.

00:12:59.160 | It's pretty easy to figure out.

00:13:01.040 | If the US ag is about 25 trillion

00:13:05.040 | in size and Yankees are two trillion of that.

00:13:08.160 | - Oh, about 8% almost.

00:13:09.960 | - Yeah.

00:13:10.800 | - Yeah, and you know, it's funny

00:13:11.620 | because a lot of people say,

00:13:12.460 | oh, we need to invest in the US bond market

00:13:15.120 | and we need to invest in foreign bonds.

00:13:17.240 | And I tell people, well, I mean,

00:13:19.200 | the US total bond market index funds

00:13:21.680 | already have this 8% already in foreign bonds

00:13:25.120 | and they're shocked at that.

00:13:26.680 | Let me ask about US strips, zero coupons.

00:13:33.440 | In the US aggregate index,

00:13:36.480 | one of the rules is that it has to be a fixed rate coupon.

00:13:40.920 | It can't be a variable rate coupon.

00:13:42.480 | It has to be fixed rate.

00:13:43.600 | Do you consider zero coupon bonds to be fixed rate bonds?

00:13:47.760 | - That's a good question.

00:13:49.200 | My answer to that would be yes,

00:13:51.920 | as long as they're originally issued as zero coupons.

00:13:54.840 | So US treasuries are stripped from normal bonds.

00:13:58.960 | So we include the normal bonds in the index.

00:14:02.520 | We don't wanna create sort of stripped out versions

00:14:06.560 | of those bonds or something that would be,

00:14:09.200 | cause us to double count those securities.

00:14:12.960 | So we just take the outstanding amount

00:14:16.160 | of the originally issued security

00:14:19.040 | and that's what goes into the index.

00:14:21.360 | - Let's talk about mortgages

00:14:22.840 | because you get the pure mortgage

00:14:24.680 | and then you've got collateralized mortgage obligations,

00:14:27.640 | packaged mortgages, if you will, tranches and so forth.

00:14:30.040 | So it would be double counting if you had both of these in.

00:14:33.000 | So which one do you count?

00:14:35.240 | - It's just the straight mortgage pools that are issued.

00:14:39.360 | We don't have CMOs in the index,

00:14:42.200 | but what we do is we take all of the residential mortgages

00:14:46.880 | as issued as pools and then aggregate those into the index.

00:14:51.880 | And as of today, there's about,

00:14:55.320 | I think it's about 25, 26% of the indexes is in mortgages.

00:15:00.320 | - And these mortgages are government backed only?

00:15:04.040 | - Yeah, or agency backed.

00:15:05.720 | So they're backed by the three agencies,

00:15:08.520 | Ginnie Mae, Freddie Mac, and Fannie Mae.

00:15:11.800 | We're tracking 30-year issuance, 15-year issuance,

00:15:14.800 | 20-year issuance,

00:15:17.040 | really where the market is most concentrated.

00:15:20.640 | And certainly there's, again,

00:15:22.760 | this is really where the bulk of the mortgage market is

00:15:25.800 | today and over time.

00:15:27.280 | As of today, again, in what we call our US ag

00:15:30.280 | or sort of the core universe,

00:15:32.400 | it's only those residential mortgages

00:15:35.000 | backed by those agencies.

00:15:36.800 | - So you've been around for 30 years now

00:15:38.360 | in this bond indexing business

00:15:40.560 | and you have seen something like the US aggregate index

00:15:44.400 | shift, not only does it shift in composition

00:15:48.120 | as more mortgages versus corporates

00:15:51.160 | or treasuries are created,

00:15:53.320 | the sectors get bigger and smaller.

00:15:56.480 | And how is the index shifting?

00:16:00.000 | How has it shifted?

00:16:01.680 | And how is it shifting?

00:16:03.920 | - Yeah, again, Rick, what we're doing every month,

00:16:07.760 | basically, just a quick background.

00:16:09.480 | Every month, we have a set of rules

00:16:11.640 | for what bonds go into the index and which don't.

00:16:14.560 | And every month, that's a monthly rebalancing.

00:16:17.120 | Every month we go out,

00:16:18.920 | we capture the bonds that meet the rules

00:16:21.440 | and we rebalance the index.

00:16:23.160 | So it's very unique.

00:16:25.360 | It's very different from stock indices, right?

00:16:28.440 | There's bonds issued all the time.

00:16:30.680 | So we wanna keep current with what the market looks like.

00:16:34.480 | And that's similar to how other competitor indices

00:16:37.720 | do it as well.

00:16:38.560 | Monthly rebalancing is fairly standard in the industry.

00:16:42.000 | But what that does is it incorporates

00:16:46.120 | and continues to show as issuance patterns differ

00:16:51.120 | and as mortgages pay down and as corporations come in

00:16:56.600 | and out of the market to issue bonds,

00:16:59.160 | what our index is doing is just reflecting

00:17:02.560 | the updated reality of the situation.

00:17:04.600 | So a good example, how have the sectors changed

00:17:09.600 | over the years?

00:17:10.560 | Well, if I look at U.S. Treasuries, for instance,

00:17:14.760 | today, U.S. Treasuries are about 39% of the overall index,

00:17:19.760 | but they've been as low as 22% down in 2002.

00:17:25.840 | They've been as high as almost 50% in 1985.

00:17:32.000 | They're sort of at one of the higher points

00:17:34.400 | that they've been in a little while,

00:17:36.800 | but it just is totally fluctuated based on

00:17:40.160 | how the U.S. Treasury is deciding to issue debt

00:17:42.960 | and in what maturities and in what size, right?

00:17:46.840 | And we just reflect that reality as the market

00:17:50.160 | just sort of evolves and that whole evolution takes place.

00:17:54.040 | So it's kind of an interesting part of it.

00:17:56.280 | You don't really see it month to month,

00:17:57.960 | but if you look at over long periods of time,

00:18:00.460 | you'll see the trends.

00:18:02.200 | And the interesting in the bond market,

00:18:03.720 | which is different than the stock market,

00:18:05.200 | is that the stock market is set by buyers and sellers.

00:18:08.000 | So the stocks you like, like Google and Apple,

00:18:11.920 | more buyers, price of the stock goes up,

00:18:14.520 | it becomes a greater percentage of the index

00:18:16.560 | because of demand, if you will, from the marketplace,

00:18:19.000 | buying more stock and pushing the valuations

00:18:22.960 | of these companies up.

00:18:23.800 | But that's not really what happens in the bond market.

00:18:25.560 | In the bond market, it's how much the issuers issue

00:18:29.000 | that determine--

00:18:29.960 | - Yeah.

00:18:30.800 | - The sector allocation.

00:18:31.840 | So it is quite different.

00:18:33.680 | - It's market value weighted.

00:18:35.240 | So price, you know, the price of a bond as it goes up,

00:18:38.120 | it will contribute a bit more,

00:18:40.560 | but it's really the main bulk of the percent weight

00:18:44.080 | of that bond is gonna be how much it has issued in debt.

00:18:48.520 | You know, we are market valuating each bond in the index.

00:18:51.920 | So price does factor in.

00:18:53.920 | But again, I think, as you said,

00:18:55.800 | it's the amount outstanding of the bond times the price.

00:18:59.800 | And there's a crude value in there too for a market value,

00:19:02.600 | but which sets the weight of a bond in the index.

00:19:06.880 | - So this year, 2022, we've seen interest rates move higher

00:19:11.800 | and the value of fixed income across the board

00:19:15.120 | has moved down because of that.

00:19:17.380 | - Yep.

00:19:18.220 | - And this function is called duration.

00:19:21.080 | So we can measure how much it's going to move down,

00:19:24.560 | the prices move down based on how much

00:19:26.280 | interest rates move up.

00:19:27.720 | Can you number one, speak about duration,

00:19:29.460 | and then talk about how duration changes

00:19:32.600 | if interest rates are very low,

00:19:34.080 | there's higher duration when interest rates are very low,

00:19:37.080 | and there's lower duration when interest rates are very high.

00:19:39.800 | Could you explain the whole concept of duration

00:19:41.680 | and how it moves?

00:19:43.640 | - Sure.

00:19:44.600 | With the U.S. ag, it's interesting because

00:19:47.280 | government and credit or corporate portions of it

00:19:50.920 | are what you call positively convex bonds,

00:19:53.680 | but the mortgage piece of it reacts actually

00:19:56.240 | the complete opposite way.

00:19:58.240 | So I'll go through that dynamic,

00:20:00.200 | but the duration of the index definitely fluctuates

00:20:04.440 | with the interest rate environment.

00:20:06.880 | It tends to be because the U.S. ag

00:20:10.840 | is about a third in mortgages.

00:20:12.800 | It's a little less than that.

00:20:13.640 | It's probably a quarter mortgages now,

00:20:15.360 | but over the course of time, it's been about a third.

00:20:19.520 | When rates move in a certain direction,

00:20:22.400 | mortgages are very, very volatile

00:20:24.840 | with respect to their durations,

00:20:26.380 | because if you get into higher interest rate environments

00:20:29.160 | like we are today, even though we're not at the peak points,

00:20:34.160 | the mortgage duration is completely dependent

00:20:37.320 | on what type of prepayments are expected in the marketplace,

00:20:40.840 | because they're all callable securities.

00:20:43.280 | If rates go low, obviously everybody's gonna pay down

00:20:46.300 | their mortgages and try to lock in a lower rate,

00:20:48.320 | and therefore the existing mortgages in the index

00:20:50.560 | are all gonna pay down, and new ones are gonna be issued,

00:20:53.880 | and so the duration can get quite low

00:20:57.180 | in low interest rate environments.

00:20:58.540 | In higher interest rate environments,

00:21:00.060 | as we've moved up recently,

00:21:02.860 | the duration of the mortgage sector

00:21:04.420 | is about in the fives right now, 5.5 if I'm not mistaken.

00:21:08.940 | It got as low as less than a year

00:21:11.660 | back in 2008 at the financial crisis

00:21:15.660 | when the rates were really dropping

00:21:17.980 | and homeowners were finding money very cheap

00:21:21.140 | and refinancing, et cetera.

00:21:22.940 | - So you were basically saying that

00:21:24.480 | when the duration was less than a year,

00:21:26.000 | that there's just a big, huge turnover

00:21:28.760 | in the mortgage market.

00:21:30.600 | People were refinancing and now that interest rates

00:21:34.080 | have moved up, a lot less of that is going on,

00:21:36.560 | so people are holding on to their mortgages

00:21:38.400 | and makes the maturity, if you will,

00:21:40.640 | of the bond much further out.

00:21:43.000 | - Much further out, much more exposed

00:21:45.760 | to interest rate risk, right?

00:21:47.360 | And in the end, duration, as you mentioned,

00:21:49.920 | is really how prices are gonna respond

00:21:53.700 | to interest rate moves.

00:21:54.620 | So it's all interest rate risk.

00:21:56.140 | That's the main risk that almost every

00:22:00.460 | fixed income investor is worried about

00:22:02.940 | is what's the duration of the index?

00:22:06.040 | What's the duration of my portfolio?

00:22:08.420 | If you are mismatched there

00:22:10.700 | and everybody knows it's tough to time duration

00:22:14.220 | or tough to time interest rates,

00:22:17.020 | you can really get on the right side of that

00:22:19.380 | and do very well, but if you're on the wrong side of it,

00:22:22.040 | it's gonna be your main reason

00:22:23.360 | why you've underperformed in fixed income.

00:22:26.220 | So if we look at the duration

00:22:28.060 | of how it's drifted over time,

00:22:30.360 | the US Ag was down at about three and a half years,

00:22:33.320 | down at that heart of the financial crisis,

00:22:35.440 | as I mentioned, in 2008,

00:22:36.840 | 'cause mortgages were so low in duration,

00:22:39.640 | but it's now at 6.6.

00:22:42.960 | So an investment in the US Ag gets you a duration of 6.6.

00:22:47.480 | And like you said, we've not had worst performance

00:22:51.640 | in the bond market in 40 years.

00:22:54.100 | The first quarter of the US Ag, we're down almost 6%.

00:22:59.000 | It was the worst quarter since 1980.

00:23:01.460 | So it's 40 years since the bond market

00:23:04.820 | has performed this poorly.

00:23:06.020 | The US Ag has generated negative returns

00:23:09.180 | in seven out of the last eight months,

00:23:11.340 | which is unheard of in fixed income.

00:23:13.460 | So it'll have a tendency to really right the ship.

00:23:16.540 | It's supposed to be a fairly stable investment,

00:23:18.840 | but when rates move directionally like this

00:23:22.140 | for extended period of time,

00:23:23.500 | which we have not seen for a long time,

00:23:25.780 | it hits every part of the bond market.

00:23:27.780 | And look, you can look at every asset class,

00:23:30.340 | not just US Ag, whether it's high yield,

00:23:32.860 | whether it's global bonds, whether it's emerging markets,

00:23:36.060 | and we all know what Russia did to that situation,

00:23:38.540 | but it's been a tough quarter for fixed income investing.

00:23:43.540 | - So we've talked about duration,

00:23:45.500 | and duration as a measure of interest rate risk,

00:23:47.540 | and the fact is when interest rates go up,

00:23:49.560 | the duration of mortgages goes up,

00:23:52.160 | but the duration of coupon bonds like treasuries

00:23:56.100 | actually goes down, correct?

00:23:58.700 | - You can kind of know how much a regular bond

00:24:00.900 | is gonna move as far as duration,

00:24:02.660 | just based on a mathematical calculation of a bond.

00:24:06.300 | And they'll move, but not as significantly

00:24:09.460 | as a mortgage-back.

00:24:10.980 | And the thing with the mortgage-back securities

00:24:13.820 | is they're dependent on the prepayment model

00:24:16.820 | you're using as well.

00:24:17.980 | So you can argue over what the duration

00:24:21.140 | of a mortgage-back security is based on,

00:24:23.540 | you know, we've got a great prepayment modeling team

00:24:25.660 | here at Bloomberg,

00:24:26.900 | but if you look at a rival index provider,

00:24:29.860 | it's gonna say the duration of the mortgage universe

00:24:32.940 | is different than what we say it is.

00:24:35.540 | - Well, let's talk about that,

00:24:36.580 | 'cause really, in a way, you're talking about

00:24:38.540 | how do you price bonds?

00:24:40.180 | And we know that a lot of the bonds in the US aggregate,

00:24:43.500 | in fact, all bonds, all bond indices have bonds

00:24:47.140 | that don't trade, unlike stocks.

00:24:49.420 | A lot of the fixed income doesn't trade.

00:24:51.780 | So these models are pricing the bonds, correct?

00:24:55.940 | And so you have to actually price each bond every day,

00:24:59.460 | even though it's not trading?

00:25:01.140 | - That's right.

00:25:01.980 | So, you know, there's different price providers

00:25:04.300 | we've used over the years.

00:25:06.660 | Our, what's called our D-Val team here at Bloomberg

00:25:10.020 | is Bloomberg's pricing service.

00:25:12.300 | And they provide all the pricing

00:25:14.620 | for the bonds in the index.

00:25:16.060 | Prior to us joining Bloomberg,

00:25:17.740 | we used a combination of vendor pricing,

00:25:20.580 | but a lot of it came from our Barclays or Lehman traders

00:25:24.900 | who were trading the bonds all the time.

00:25:27.220 | And we did have a pricing team back then,

00:25:29.780 | which would work with them and price the index.

00:25:32.180 | So the pricing of the index has evolved over time,

00:25:35.860 | and now we're using pure D-Val prices.

00:25:39.420 | They do a great job of pricing the universe,

00:25:41.220 | but you're right.

00:25:42.260 | For the bonds that you are able to see,

00:25:45.380 | you know, trades on every day,

00:25:47.180 | or bids or offers on every day,

00:25:49.940 | you can price those very, very well.

00:25:53.380 | Part of the universe does have to be model price.

00:25:56.060 | Like if a bond of a certain issuer,

00:25:58.660 | if you can price that one fairly well,

00:26:00.940 | but the other one doesn't trade,

00:26:03.020 | you're gonna have to deduce sort of a movement of that bond

00:26:06.580 | or what's called the spread of that corporate bond

00:26:09.460 | relative to treasuries fairly in line

00:26:11.980 | with how the other bond of that issuer moved.

00:26:16.980 | There's other ways to model bonds as well,

00:26:19.380 | bonds of a similar quality, industry, that type of thing.

00:26:22.980 | But universes like treasuries are very easy and liquid,

00:26:26.220 | and you could come up with really, really quality prices.

00:26:29.380 | And for most of the bonds in the index,

00:26:32.220 | you could definitely have observations for,

00:26:35.300 | but others you're gonna have to model price for sure.

00:26:38.660 | - Now the index funds themselves,

00:26:41.580 | the ones who are managing the index funds,

00:26:43.180 | they also have to price their portfolios on a daily basis.

00:26:46.860 | And some of the bonds in those portfolios

00:26:48.620 | may not trade on a daily basis.

00:26:51.420 | So are they using the same pricing

00:26:53.580 | or is there some discrepancy between what they're using

00:26:56.060 | and what you're using?

00:26:57.060 | - Yeah, that's a great question,

00:27:00.220 | probably a great one for Josh as well.

00:27:02.300 | But yeah, they have to use services or pricing services

00:27:07.460 | to price their portfolios.

00:27:08.780 | In some cases, they will use BVAL

00:27:10.820 | because they believe in the quality of those prices

00:27:13.860 | and they'll use BVAL.

00:27:16.220 | Not every client does.

00:27:18.580 | There's many other competitor pricing services out there

00:27:21.900 | that do a good job.

00:27:23.540 | And clients use who they feel

00:27:26.980 | are the right pricing vendor for them.

00:27:29.760 | But you're right in the saying that

00:27:32.620 | if an investor is using a different pricing service

00:27:36.460 | than the index, you could be exactly matched

00:27:39.860 | on every constituent of the index

00:27:42.100 | but still show different performance than the index

00:27:44.820 | because of the difference in pricing services.

00:27:47.540 | So it's not an exact science, that's for sure.

00:27:50.780 | So you will have some tracking error because of that.

00:27:54.180 | - So last question and we'll wrap it up.

00:27:55.940 | And this has to do with derivatives, if you will,

00:27:59.140 | off the US aggregate.

00:28:00.460 | And I know that Vanguard uses a float-adjusted.

00:28:04.540 | As far as the float-adjusted index,

00:28:06.500 | there's bonds in the market that are held by the Fed.

00:28:11.500 | And certainly as part of the financial crisis,

00:28:15.340 | the Fed's always bought treasuries.

00:28:17.900 | And just in all transparency,

00:28:20.600 | those have always been excluded from the US ag from day one.

00:28:24.340 | That's just part of our methodology

00:28:26.100 | 'cause it was a very consistent pattern

00:28:28.680 | and it's been baked in as part of the methodology forever.

00:28:31.980 | So the amount of treasuries in the float-adjusted

00:28:35.980 | and in the standard US ag are exactly the same, okay?

00:28:40.700 | The mortgages though were another debate back in 2009

00:28:44.540 | once the Fed started buying mortgages.

00:28:47.900 | Should we take them out of the index

00:28:49.820 | or should we keep them in?

00:28:51.300 | 'Cause they had never been in the game before.

00:28:54.380 | Back then, nobody knew how long it was going to last

00:28:58.540 | nor did we actually have the information at a Q-SIP level,

00:29:03.540 | especially early on, to start taking them out.

00:29:07.340 | We can't just guess.

00:29:08.820 | Over the course of time,

00:29:10.140 | and the information became more transparent,

00:29:13.260 | but when we were trying to make a decision

00:29:15.180 | about what should we do with all this,

00:29:19.140 | with the Fed holdings of MBS,

00:29:21.620 | there was, again, a lot of good conversation

00:29:23.980 | with this about our clients.

00:29:25.780 | Due to the uncertainty of how long the Fed

00:29:27.620 | was going to be in the game,

00:29:28.820 | should we take out all the bonds

00:29:30.140 | and then have to put them back in and that type of thing?

00:29:32.940 | There's a lot of good points brought up.

00:29:35.220 | So that's how the float-adjusted version

00:29:38.460 | of the US ag was born was the main difference

00:29:42.500 | is the amount of mortgages in the two indices.

00:29:45.900 | So if I could give you a couple stats,

00:29:48.100 | it's the mortgage part of the index.

00:29:51.660 | Our US ag has about 30% in securitized

00:29:56.820 | and that's mortgages plus only a small portion

00:29:59.740 | of ABS and CMBS.

00:30:02.140 | The float-adjusted ag has 22.3.

00:30:06.900 | So we're almost seven and a half percent less

00:30:10.580 | in terms of securitized debt in the float-adjusted index.

00:30:13.740 | And that means the other sectors just go up a scaled amount.

00:30:18.100 | So there's basically more corporate bonds

00:30:22.660 | in the float-adjusted ag and there's more treasury bonds

00:30:26.940 | in the float-adjusted ag.

00:30:28.260 | - So which one outperformed this last quarter?

00:30:32.300 | - I looked at that and the difference

00:30:35.300 | was only seven basis points.

00:30:36.980 | - Oh, is that all it was, okay.

00:30:39.220 | - It was really minor.

00:30:40.900 | Now, again, I haven't done all the attribution on it,

00:30:44.060 | but as of right now, the difference in,

00:30:48.940 | you would think the different, the duration of the,

00:30:53.740 | because we've talked about mortgages being

00:30:57.660 | at their highest duration in a while,

00:31:00.820 | but the curious part is the duration

00:31:06.220 | of the other components is higher

00:31:10.100 | than the overall duration of the US ag.

00:31:13.500 | So even though securitized or mortgages

00:31:18.220 | at their highest in a while,

00:31:20.460 | it's still not the same duration as the other components.

00:31:24.780 | So that being said, the float-adjusted index

00:31:29.420 | is about 0.15 years longer in duration

00:31:33.140 | than the standard US ag is right now.

00:31:36.220 | - So not much, not much.

00:31:38.380 | Well, Nick, it's been extremely educational.

00:31:40.180 | Thank you so much for being on BogleHeads on Investing

00:31:43.020 | and we greatly appreciate all of the insights

00:31:45.900 | and good luck with the next 30 years in this industry.

00:31:49.260 | - Really appreciate you having me on today

00:31:52.620 | and look forward to speaking with you soon.

00:31:55.500 | - Our next guest is Joshua Barrichman,

00:31:58.020 | Principal and Head of Fixed Income Index Investing

00:32:01.420 | at Vanguard.

00:32:03.100 | So let me introduce Josh Barrichman.

00:32:05.380 | Welcome to BogleHeads on Investing, Josh.

00:32:07.700 | - Thanks for having me.

00:32:09.060 | - Josh, you've been at Vanguard since 1998

00:32:13.220 | and now you're the Head of Bond Indexing,

00:32:16.780 | managing about a trillion dollars in assets.

00:32:19.620 | So it's a big responsibility.

00:32:22.420 | But before we jump into bond index funds

00:32:25.660 | and the total bond market index fund,

00:32:27.780 | could you tell us a little bit about yourself,

00:32:29.540 | a little about your background?

00:32:30.580 | How did you get into this position?

00:32:32.420 | - Yeah, sure, happy to.

00:32:34.700 | So I grew up in Ohio and went to school out there,

00:32:37.980 | studied finance, made my way East

00:32:42.300 | to go to business school

00:32:43.700 | and started up with Vanguard in 1998

00:32:46.180 | in one of our tax departments.

00:32:48.900 | Did that for about 12 months

00:32:51.020 | and got an opportunity at that point

00:32:52.900 | to move to the fixed income group

00:32:54.940 | as a trader for our municipal bond funds.

00:32:57.620 | So I was able to do that for three years,

00:32:59.260 | trading various different asset classes within municipals.

00:33:03.420 | And then in 2002, had the opportunity to move over

00:33:06.660 | to our fixed income index team,

00:33:08.900 | which at the time was a rather small team,

00:33:11.780 | maybe eight folks total,

00:33:13.420 | but a really great opportunity for me coming up

00:33:16.060 | to really get to work with some luminaries in the field

00:33:18.900 | of indexing, folks like Ken Volper, Craig Davis,

00:33:22.700 | Chris Allwine.

00:33:24.100 | Was able to grow my career on the index desk,

00:33:26.220 | various roles as trader, portfolio manager

00:33:29.020 | across a lot of different asset classes.

00:33:31.340 | Then in 2013, I took over as head of the desk

00:33:34.340 | and I've really been in that role ever since.

00:33:36.820 | You know, the index desk in particular

00:33:39.340 | has been really a dynamic place to work

00:33:41.860 | and have a career just with just the amount

00:33:43.780 | of different markets that we've banded into, ETFs,

00:33:47.580 | kind of list goes on and on in terms of how the business

00:33:50.300 | has grown and changed over the time I've been there.

00:33:52.140 | So it's been a great place to have a career.

00:33:54.980 | - How many different funds are you responsible

00:33:58.340 | for managing both the US and internationally?

00:34:02.180 | - Yeah, so the global footprint for bond index

00:34:05.820 | is around, you know, 80, 85 different mandates.

00:34:09.100 | Kind of depends how you classify certain things,

00:34:11.420 | but yeah, about 85 mandates

00:34:13.980 | and just around a trillion dollars in AUM.

00:34:16.820 | - And how much of that is US versus outside the US?

00:34:20.500 | - Yeah, the bulk of it is definitely in the US.

00:34:22.980 | You know, I would say the breakdown's probably around 80, 20.

00:34:26.420 | - And the flagship product in the US

00:34:29.100 | is the total bond market, all share classes?

00:34:32.300 | - That's right.

00:34:33.140 | - And by the way, you have different

00:34:34.180 | total bond markets, correct?

00:34:35.380 | You have the total bond market one,

00:34:36.900 | you have the total bond market two,

00:34:38.620 | you have total bond market ETF.

00:34:39.980 | How many different total bond market funds are there?

00:34:42.340 | - There's really two.

00:34:43.380 | There's total bond market and total bond market two.

00:34:46.900 | The ETF, you can really think of as an extension

00:34:50.020 | or a different share class within total bond market one.

00:34:52.980 | It's really just a share class of that fund.

00:34:56.140 | There's the total bond market two product,

00:34:58.380 | which is really in place to serve as the bond option

00:35:02.780 | for some of our multi-asset strategies.

00:35:06.220 | - Is there any difference between how they're managed?

00:35:08.980 | - No, they're gonna be pretty close to one another

00:35:11.540 | in terms of overall strategy and composition.

00:35:14.740 | For different reasons, for cash flows and things like that,

00:35:17.940 | you will have some deviations,

00:35:19.460 | but we're talking very much at the margin.

00:35:22.860 | - Well, I have some question about if one fund,

00:35:25.660 | one bond index fund, total bond market index fund,

00:35:30.020 | needs a bond and total bond market index fund number two

00:35:33.900 | has a bond, is it legal to just move it

00:35:37.140 | from one fund to another at NAB?

00:35:39.380 | Can you do that?

00:35:40.460 | - It is, it is currently.

00:35:41.940 | Those rules are likely changing in the short term,

00:35:45.100 | but there is a process that we can go through

00:35:47.380 | that allows us to cross trade between funds.

00:35:51.180 | There's an approved process with our risk team

00:35:53.660 | to make sure that everyone's being treated fairly.

00:35:55.500 | But as of right now, that is doable going forward.

00:35:59.780 | And like I said, the rules will be changing around that.

00:36:02.820 | - Is that because of SEC or because of Vanguard?

00:36:05.380 | - An SEC rule change, yeah.

00:36:08.860 | - Oh, interesting.

00:36:09.700 | So the bond would actually have to go out of one fund

00:36:12.100 | to someplace else and then come back into the other fund?

00:36:14.900 | - Yeah, the two funds would not be able to cross

00:36:17.820 | directly with one another.

00:36:19.180 | Given kind of the nature of the bond market,

00:36:23.860 | it's not a guarantee that that particular bond

00:36:26.260 | would make its way back to the other fund.

00:36:29.500 | There's a lot of friction in the fixed income markets

00:36:32.460 | relative to an exchange traded market

00:36:34.700 | where certain bonds are gonna be available certain days

00:36:39.060 | and then they may not trade other days.

00:36:40.380 | So you can never be sure that you're gonna be able

00:36:43.940 | to get the bond that you want when you want it.

00:36:46.060 | - You have a short-term bond index fund,

00:36:48.220 | intermediate-term bond index fund,

00:36:50.100 | and so there's different pieces of, say,

00:36:53.340 | the aggregate bond market that are broken up

00:36:55.180 | into different maturities, different credit ratings.

00:36:58.740 | And right now, if a bond,

00:37:01.980 | let's say that was in the intermediate-term

00:37:03.660 | corporate bond fund, got to a certain maturity

00:37:06.540 | where it would normally be sold,

00:37:08.540 | and the short-term corporate bond fund index fund needs it,

00:37:12.260 | you could move it in, but what you're saying going forward,

00:37:16.140 | you may not be able to do that?

00:37:17.540 | - That's right.

00:37:18.380 | At least not directly in between the two.

00:37:21.820 | Again, an NSEC rule would prohibit that going forward.

00:37:25.100 | - Is that rule already in place

00:37:26.260 | or are you just anticipating it's going to happen?

00:37:28.540 | - It'll be in place, I believe, in September of this year.

00:37:31.620 | - Do you think this will add costs

00:37:33.220 | to managing these portfolios?

00:37:35.180 | - Yeah, we've kind of gone through

00:37:37.940 | a lot of different scenario analysis

00:37:39.460 | of how we can handle this,

00:37:40.860 | and at the end of the day, it's pretty de minimis.

00:37:43.940 | In some ways, it adds opportunity for us

00:37:45.740 | to be a little bit more strategic

00:37:48.060 | on how we move bonds from one fund to another.

00:37:51.660 | Throughout the month, we may have opportunities

00:37:53.700 | where, because of new issues, we might be overweight credit,

00:37:56.300 | and that might be a decent time

00:37:57.540 | to sell out of those bonds that you described

00:38:00.900 | that might be falling out of that benchmark

00:38:02.660 | and things like that.

00:38:03.780 | So we've kind of gone through a lot of different iterations

00:38:06.180 | and feel like we're in a pretty good place

00:38:07.940 | to have a small, if any, impact to the funds.

00:38:12.140 | - So the total bond market itself,

00:38:14.300 | the index that you're tracking

00:38:16.900 | is the Bloomberg US Aggregate Float Adjustment Index,

00:38:21.900 | and that index has 12,500 bonds in it.

00:38:25.500 | And according to the latest information

00:38:27.780 | on the Vanguard website,

00:38:28.980 | the total bond market fund has about 10,150.

00:38:32.940 | So this is a discrepancy there of maybe 2,300 bonds.

00:38:37.940 | And so why would there be such a large discrepancy?

00:38:41.980 | Whereas if this was a stock index fund,

00:38:44.740 | it would generally be almost every stock

00:38:46.580 | that trades out there.

00:38:47.860 | So why is it not that way with bonds?

00:38:50.060 | - Yeah, it's a good question, Rick.

00:38:51.300 | I mean, the example, I think that kind of clarifies it a bit

00:38:54.180 | is you've got stock index funds

00:38:55.940 | that have securities that trade on exchange.

00:38:58.620 | So something like an S&P 500,

00:39:00.340 | it's quite easy to go out and buy those 500 stocks

00:39:03.260 | in the right proportions and get tracking that benchmark.

00:39:06.740 | What you don't have in the bond market

00:39:08.260 | is that same exchange traded mechanism.

00:39:10.020 | So everything in the bond market trades over the counter,

00:39:13.140 | which really means that as a trader or PM,

00:39:16.140 | you need to go out and find the bonds

00:39:18.100 | that you need to trade.

00:39:20.580 | And you also have a dynamic

00:39:22.260 | that the fixed income market

00:39:23.700 | is really a buy and hold market.

00:39:25.700 | A lot of securities that don't trade,

00:39:27.420 | that get purchased at new issue

00:39:29.220 | and get the term is put away.

00:39:30.980 | They get put into someone's portfolio

00:39:32.580 | and you really don't see them come out.

00:39:34.940 | So what sort of happens then is because of those dynamics,

00:39:39.220 | myself, my team, we need to go out

00:39:41.540 | and build samples of the markets

00:39:44.660 | to replicate the major risk factors

00:39:47.100 | to ensure that we're gonna get tight tracking.

00:39:49.700 | But we need to do it in a way

00:39:51.420 | that understands that there are limitations

00:39:53.020 | of what we can and can't buy.

00:39:54.660 | And we have to be by definition,

00:39:56.580 | overweight some things and underweight other things.

00:39:59.340 | The team here will break the market

00:40:01.340 | into sort of subcomponents.

00:40:02.900 | And we have experts that will be responsible

00:40:05.700 | for building the sample within that subcomponent

00:40:08.700 | with a bent toward trying to add a little bit of value

00:40:12.260 | at the margin.

00:40:13.260 | Tracking is always job one for us,

00:40:14.860 | but understanding that we have to be overweight

00:40:17.340 | some places and underweight others.

00:40:18.500 | We try to do that pretty deliberately,

00:40:20.620 | leverage our credit resources, credit research team,

00:40:23.900 | as well as our traders' expertise

00:40:25.900 | to continually buy bonds that are a little bit cheaper,

00:40:29.420 | sell the bonds that are a little bit richer.

00:40:30.980 | And over time, you have that accrued to the funds.

00:40:33.940 | - And in your analysis, how much of that

00:40:35.980 | has actually accrued to the funds?

00:40:37.340 | Did you have like a basis points

00:40:38.940 | or something that you could point to and say,

00:40:40.340 | yes, we actually added this much value

00:40:42.460 | by doing that type of trading?

00:40:44.260 | - Yeah, it's not a typical year.

00:40:45.900 | We're not talking about huge numbers here

00:40:47.660 | in terms of basis points.

00:40:49.380 | One to two basis points would be pretty typical year.

00:40:53.220 | First of all, we're generally able to overcome

00:40:55.060 | our transactions costs and then even to the expense ratio

00:40:57.900 | by maybe a basis point or two basis points.

00:41:00.260 | So not huge in terms of basis points,

00:41:02.980 | but when you convert that into dollars and cents,

00:41:05.580 | you're talking about some pretty big numbers.

00:41:07.940 | - So the total bond market has a ETF

00:41:10.900 | attached to it as a share class,

00:41:12.980 | but that trades differently than cash

00:41:15.700 | coming into the total bond market fund itself.

00:41:19.660 | And the ETF share class, according to the data

00:41:22.420 | on your website is about 83 billion or so

00:41:27.300 | of that 300 billion in the total bond market.

00:41:29.900 | What I'm really curious about is,

00:41:31.060 | does it enhance the fund in some way?

00:41:33.300 | In other words, the performance or does it lower the cost

00:41:35.900 | because you have this ETF share class?

00:41:39.580 | - Yeah, like you mentioned, it's really just a,

00:41:42.420 | it's a separate share class of the total bond one fund.

00:41:47.020 | So a lot of ways we're indifferent

00:41:49.060 | about how cash comes to us.

00:41:51.060 | If it comes through the mutual fund,

00:41:52.540 | it's more traditional in cash.

00:41:54.060 | If it comes to us through the ETF channel,

00:41:56.820 | it's gonna be more of an in-kind bonds.

00:41:59.180 | Having the ETF attached,

00:42:00.740 | it has a couple of nice benefits for us.

00:42:02.860 | It allows us to add additional diversification

00:42:05.940 | through the ETF channel as we negotiate custom baskets

00:42:09.980 | with market makers and we're taking those in every day.

00:42:13.460 | You're able to take those in on the bid side of the market.

00:42:16.100 | So in a way we're able to grow the asset base

00:42:19.260 | without explicit transactions costs attached to it.

00:42:23.140 | And there's also some tax deferral benefits

00:42:25.180 | through the in-kind process.

00:42:26.620 | And when we do have redemptions,

00:42:28.100 | we're able to send out some of the lower cost lots

00:42:31.380 | that we might otherwise have to trade at a gain.

00:42:34.620 | So those couple of things are additive

00:42:37.060 | to the mutual fund shareholders from the ETF.

00:42:39.660 | - Let me circle back to just the observation

00:42:42.300 | about the titling of the total bond market index fund.

00:42:46.260 | And the reason I circled back to this

00:42:48.580 | is because when I interviewed Nick from Bloomberg,

00:42:53.580 | they call it an aggregate bond,

00:42:56.900 | a US aggregate bond market index,

00:42:59.940 | but Vanguard calls the fund a total bond market index.

00:43:04.940 | So could you explain,

00:43:07.580 | why does, I guess my question would be,

00:43:09.580 | why doesn't Vanguard call it

00:43:11.260 | the US aggregate bond market index?

00:43:12.980 | Why is it the total bond market?

00:43:15.220 | - Yeah, it's really the broadest fund that we offer,

00:43:18.300 | at least that's purely US focused.

00:43:21.340 | It's really probably the investment grade component of it

00:43:23.420 | that we would say is the total investment grade market.

00:43:26.580 | And some of the components

00:43:27.740 | that people might argue should be included

00:43:30.060 | would be things like high yield and EM,

00:43:31.700 | but then you're sort of straying outside

00:43:33.460 | of this investment grade mandate.

00:43:36.980 | And frankly, I think people have certain expectations

00:43:40.500 | of bonds that probably align a lot more

00:43:42.980 | with investment grade performance

00:43:44.580 | versus being in something that's high yield

00:43:46.620 | or emerging markets that at times

00:43:49.100 | they're gonna trade a lot more

00:43:50.820 | with a higher high beta to equities at times.

00:43:54.500 | So it's really the investment grade piece

00:43:57.020 | that we're wrapping that total label around.

00:43:59.940 | - I think it was 2010 Vanguard decided

00:44:03.740 | that they wanted to change the index

00:44:06.220 | that they were tracking slightly to a float adjusted index.

00:44:10.820 | And this is different than your competitors like iShares.

00:44:13.380 | Why Vanguard made that change

00:44:15.260 | and made that decision to go that direction?

00:44:17.500 | - Sure, in terms of the float adjustment,

00:44:19.940 | the standard US aggregate has always adjusted

00:44:23.420 | for Fed holdings of treasuries.

00:44:25.860 | So if you compare the ag versus float adjusted ag,

00:44:29.380 | that component is the same.

00:44:32.100 | Where there was a deviation

00:44:33.980 | was when the Fed started to buy mortgage securities,

00:44:38.500 | post GFC and start to take those onto their balance sheet.

00:44:42.700 | The decision was made that the sort of top level ag

00:44:46.980 | was not going to adjust for those.

00:44:49.420 | We felt pretty strongly that it would be best practice

00:44:52.260 | to adjust for float that's being taken out of the market.

00:44:55.900 | Really the biggest difference as you see between the two

00:44:58.020 | is the weight in mortgages is quite a bit lower

00:45:01.740 | and the float adjusted, but that then redistributes

00:45:04.020 | the entire pie.

00:45:04.860 | So you'll get a bit higher in credit exposure,

00:45:07.780 | you'll get a bit higher in treasury exposure.

00:45:10.780 | We felt it was best practice.

00:45:12.180 | We don't wanna be trying to buy in markets

00:45:14.660 | where we know that the Fed is out there

00:45:16.860 | and in somewhat of an uneconomic way

00:45:18.860 | taking supply out of the market,

00:45:20.740 | but it's not perfect, right?

00:45:21.660 | You could argue, like I said, it's a buy and hold market.

00:45:24.540 | There's a lot of bonds that are on balance sheets

00:45:26.740 | of foreign banks on insurance companies or pensions

00:45:29.820 | that are probably never gonna trade,

00:45:31.060 | but the data to really do something like that

00:45:33.580 | just really isn't that reliable and available.

00:45:36.140 | So we felt it was a good step.

00:45:38.700 | We felt it was the right step for our investors.

00:45:42.460 | Looking at it over five year look back,

00:45:46.420 | float adjusted has outperformed slightly,

00:45:49.620 | hasn't really been dramatic,

00:45:51.300 | but a slight outperformance over a five year period.

00:45:55.220 | But what you will see too is as the Fed

00:45:58.980 | is going to unwind QE and let mortgages roll off

00:46:03.980 | and let treasuries roll off

00:46:06.300 | and potentially if they get more active actually sell,

00:46:10.220 | what you will see is that float come back into the market

00:46:12.980 | and you'll see a convergence then

00:46:14.980 | between the float adjusted ag

00:46:16.540 | and sort of the standard ag.

00:46:18.740 | - Well, let's talk about return for a minute

00:46:21.180 | because it has been a difficult market here for investors.

00:46:24.980 | I think that Nick was telling us

00:46:26.660 | that you had to go all the way back to I think the 1970s

00:46:29.660 | to find a period of time when in one quarter

00:46:32.060 | the aggregate bond market lost as much as it did

00:46:34.620 | in the first quarter of 2020.

00:46:36.340 | So I wanna talk about the different elements of return,

00:46:40.380 | coupon yield, roll yield, capital appreciation,

00:46:42.900 | all the things that go into the return.

00:46:45.380 | - Yeah, sure.

00:46:46.220 | Really when you're investing in bonds,

00:46:47.540 | you're generally investing to earn that yield

00:46:50.020 | and that yield is really a combination of coupon

00:46:53.020 | as well as the dollar price of the bonds

00:46:55.780 | in the portfolio at the time

00:46:57.500 | and sort of taken together that will give you a yield

00:46:59.900 | and that should be a pretty good estimation

00:47:02.620 | of what you should expect to earn

00:47:04.140 | over at least the short term.

00:47:06.420 | We've obviously come from a period of really low rates.

00:47:09.780 | A lot of times we'll think about things

00:47:10.900 | in terms of like breakeven spread moves

00:47:14.460 | or breakeven interest rate moves.

00:47:15.980 | And when you're at such a low level of yield,

00:47:18.340 | a very low hurdle rate in terms of the yield

00:47:20.660 | that you're looking to earn or expecting to earn,

00:47:23.100 | it doesn't take much in terms of a backup in rates

00:47:25.340 | before you overwhelm that yield

00:47:27.500 | and you actually go negative in total return.

00:47:30.100 | And that's what we've seen obviously

00:47:31.500 | over the past couple of quarters

00:47:33.500 | as inflation has kicked up

00:47:35.460 | and the Fed has been very vocal about their plans.

00:47:39.900 | The golden rule that you always have to keep in mind

00:47:42.060 | is that rising rates aren't always a bad thing.

00:47:44.660 | It really has to do with your investment horizon

00:47:47.380 | and the product that you're in.

00:47:49.180 | So rule of thumb would say

00:47:50.660 | that if you have an investment horizon

00:47:52.420 | that's longer than the duration of your fund,

00:47:55.180 | you should actually welcome higher rates

00:47:57.380 | because what's gonna happen

00:47:58.220 | is you're gonna have an opportunity.

00:48:00.100 | You know, as yields are higher,

00:48:00.940 | you're gonna continue to reinvest

00:48:02.260 | and that will continue to sort of accrue and compound

00:48:05.580 | through the life of that investment.

00:48:06.860 | So like anything, it's always important

00:48:09.620 | to make sure you've got the right product.

00:48:11.300 | It's within your risk tolerance or risk budget

00:48:14.500 | and you're able to ride it out

00:48:16.660 | because you are in the right product.

00:48:19.540 | - I wanna talk about the concept of roll yield

00:48:22.300 | where you've got a yield curve now that's very steep

00:48:25.260 | and the total bond market aggregate,

00:48:28.300 | US aggregate index, once a bond gets to one year,

00:48:32.500 | it comes out of the index

00:48:34.180 | because now it's a cash element, it's a cash security.

00:48:37.380 | If you're buying these at five years or six years

00:48:40.660 | and you hold it until one year,

00:48:42.740 | but you don't hold it to maturity,

00:48:43.980 | there's an excess return that you could pick up

00:48:46.660 | if you have this normal yield curve.

00:48:48.700 | Can you discuss that and how that's affecting

00:48:51.260 | or how that has affected the return

00:48:52.900 | of this fund over the years?

00:48:54.740 | - Just kind of going back to this idea

00:48:56.740 | that we're building samples,

00:48:59.780 | we make a lot of active decisions on a daily basis

00:49:02.540 | within kind of the construct of bond indexing,

00:49:04.860 | again, with tracking as a number one goal,

00:49:06.940 | but if something like you described,

00:49:09.060 | we're not mandated to sell something that goes under a year

00:49:12.260 | and if it's really attractive, we'd be happy to hold that.

00:49:15.340 | And maybe that's a trade off somewhere else in the fund

00:49:18.740 | within our risk budget,

00:49:21.060 | but we always have the lens of, does that make sense?

00:49:24.580 | Can we hold onto a bond that has,

00:49:26.380 | we think has a lot of value

00:49:27.860 | and not take a bunch of risks elsewhere?

00:49:30.020 | You certainly can't do that all the bonds

00:49:32.340 | that are going to fall under a year

00:49:33.260 | or else you would end up taking a curve bet somewhere

00:49:36.020 | along the yield curve in the fund.

00:49:37.580 | But there is a lot of discretion for us to do that

00:49:40.940 | when those opportunities arise.

00:49:43.060 | - We got a question that came up with Nick

00:49:45.300 | and it had to do with pricing bonds

00:49:47.380 | because we've already discussed the fact

00:49:49.180 | these bonds that you have in your fund are put away.

00:49:52.100 | They don't trade, but they need to be priced every day.

00:49:55.180 | And Nick was telling us about the services

00:49:57.820 | that they use to price their bonds

00:50:01.020 | and does Vanguard use the same services or is it different?

00:50:05.900 | And if it's different,

00:50:07.340 | how does it affect the NAV of the index versus the portfolio?

00:50:12.860 | - In most cases, we don't use the same service.

00:50:15.380 | There are some pockets where we do.

00:50:17.940 | For us as an index fund provider,

00:50:20.900 | that would probably be the lowest tracking option

00:50:24.140 | for us would be to use whatever value

00:50:25.940 | that our index providers come up with.

00:50:28.460 | We found over the years

00:50:29.500 | that we want to take a little bit more of a broader look

00:50:31.660 | and use a variety of different pricing services.

00:50:35.540 | So we bring in two or three or more prices every day

00:50:40.340 | for different markets.

00:50:42.140 | Our pricing team within our fund accounting group

00:50:44.700 | will do the due diligence to really quality check

00:50:48.300 | all the different pricing sources

00:50:49.820 | and use the ones that we really think are most accurate

00:50:53.100 | for that particular sector and that particular fund.

00:50:55.700 | - Well, let me ask another question,

00:50:57.900 | maybe a little bit tougher.

00:50:59.540 | When the bond market has a bad day

00:51:03.500 | and credit spreads just widen very rapidly

00:51:06.540 | and the liquidity just dries up, ETF prices plummet.

00:51:11.540 | And sometimes ETFs close at much lower prices

00:51:16.220 | than their fund, their index fund equivalent.

00:51:19.620 | I think we might've seen this back in 2020,

00:51:22.580 | might've seen it back in 2007, 2008,

00:51:25.500 | where we've seen this big gap

00:51:27.260 | between market price of the ETF at close

00:51:31.060 | and the actual NAV of the opened end fund.

00:51:34.900 | And I think that a lot of people try to explain it.

00:51:37.180 | A lot of people are saying that this is actually fair,

00:51:39.740 | but number one, could you explain what happens

00:51:41.500 | and your view of all that?

00:51:43.220 | - Sure, yeah.

00:51:45.060 | So I think the example that you probably,

00:51:47.020 | or at least is most fresh in mind is March, 2020,

00:51:49.740 | when you saw for a small period of time,

00:51:52.580 | bond ETFs closing at relatively large discounts to NAV.

00:51:57.180 | I think the first thing I would say

00:51:58.180 | is that was a really unprecedented period of volatility

00:52:01.060 | for the fixed income ETFs.

00:52:02.820 | And it was a pretty big test for how resilient

00:52:06.500 | they would be.

00:52:07.500 | I guess I'll go back to, first of all,

00:52:10.260 | the diligence that we put into our NAV

00:52:12.500 | makes us feel really good about where we're coming in

00:52:15.740 | every night with NAV pricing.

00:52:18.220 | So the deviation on the ETF side has a lot to do

00:52:22.020 | with sort of the price of liquidity at that time

00:52:24.780 | in the marketplace and the demand

00:52:27.940 | for sort of instant liquidity taking place

00:52:30.300 | when you have a market that's somewhat frozen up.

00:52:33.060 | And then you think about, okay, well,

00:52:34.820 | there should be this arbitrage mechanism

00:52:36.300 | that brings things back in place,

00:52:38.620 | but then you got to kind of think about

00:52:41.220 | the state of the market where it was

00:52:42.940 | and the arbitrage trades that would need to happen

00:52:45.260 | to close up that gap.

00:52:48.060 | And that would sort of involve someone going out,

00:52:50.020 | buying shares in the market, redeeming them to the fund

00:52:53.660 | and getting bonds in return.

00:52:55.940 | And in an environment like that,

00:52:57.980 | from hour to hour, from minute to minute,

00:53:00.020 | you don't really know what those bonds could be worth.

00:53:02.180 | They could gap lower by two points

00:53:03.780 | by the time you get around to actually liquidating

00:53:05.780 | and trying to affect that arbitrage.

00:53:09.300 | So there's just so much uncertainty and friction

00:53:12.540 | that that arbitrage mechanism definitely gets weakened

00:53:15.180 | a bit in those times.

00:53:16.740 | But big picture, there were some small blips,

00:53:23.420 | but for the most part, we were very encouraged

00:53:26.340 | of how the fixed income market behaved

00:53:29.140 | and how resilient it was and how big of a part it was

00:53:31.500 | in terms of kind of ultimate price discovery

00:53:34.340 | over the course of a few months

00:53:35.860 | as the market tried to right itself

00:53:37.780 | and work out some of the volatility

00:53:40.300 | and the dislocation that we had seen.

00:53:43.100 | - So most people who are buy and hold investors

00:53:45.820 | or should just kind of ignore these daily fluctuations,

00:53:49.140 | unless perhaps you wanted to do some rebalancing,

00:53:52.780 | in which case, if you wanted to do some rebalancing

00:53:55.540 | and that day in March where things went crazy

00:53:58.700 | and the gap between the trading price of the ETF

00:54:02.860 | and the NAV of the open-end fund was so wide

00:54:07.420 | that it would have been better off selling the open-end fund

00:54:10.820 | if you had those shares rather than the ETF.

00:54:13.620 | - Right, the open-end fund

00:54:16.620 | would have probably been a better option at that time,

00:54:19.420 | but there's reasons that people hold the ETF

00:54:22.220 | and some of it is this instant liquidity,

00:54:26.740 | getting out midday.

00:54:29.380 | We also have some frequent trading policies

00:54:32.220 | that would restrict folks from coming into

00:54:36.220 | and out of the total bond mutual funds,

00:54:39.020 | which wouldn't occur in the ETF.

00:54:41.500 | So there's a lot more flexibility there as well.

00:54:43.340 | So there's a little bit of trade-offs on both sides.

00:54:46.500 | - Are you finding it more difficult trading bonds

00:54:49.620 | with the current environment?

00:54:51.380 | Ben talking about higher interest rates and so forth.

00:54:53.540 | Does this create some illiquidity in the market?

00:54:55.980 | Is it more difficult for your desks?

00:54:57.900 | - I wouldn't say it's anything that's unexpected

00:55:01.620 | or out of the ordinary in a period of volatility like this.

00:55:05.060 | I think anytime you go through this,

00:55:06.340 | there's a bit of a price discovery process.

00:55:08.820 | It takes the market a while to settle in

00:55:10.940 | sort of back to more normal levels.

00:55:12.780 | So there's a bit of it for sure,

00:55:14.500 | but yeah, I would say it's well within what we would expect.

00:55:18.180 | - You're an important person.

00:55:19.260 | You're managing a lot of money for a lot of people.

00:55:22.540 | Is there anything you wanted to add to this conversation?

00:55:26.420 | - I mean, I could just maybe offer a couple of thoughts.

00:55:28.620 | We're obviously talking about total bonds today,

00:55:30.220 | but Vanguard has a really full lineup

00:55:32.700 | of both active and index products in the bond market

00:55:37.100 | that really offer investors with a lot of options

00:55:40.500 | and a lot of flexibility to tailor that bond exposure.

00:55:44.500 | And we do believe in total bond as a core,

00:55:46.740 | but core doesn't mean a hundred percent.

00:55:49.140 | If somebody is of the mind

00:55:51.500 | that they want more corporate exposure

00:55:53.940 | or they want a shorter duration or a longer duration,

00:55:56.700 | we have a lot of great options to supplement that exposure

00:56:00.060 | and make sure people get the risk

00:56:01.540 | that they're comfortable with

00:56:02.580 | and the risk that kind of fits

00:56:03.980 | their long-term asset allocation.

00:56:06.420 | So again, total bond, we think is a great core,

00:56:10.300 | but there's a lot of other sort of building blocks.

00:56:12.980 | We would call them to add on to build a bond portfolio

00:56:16.260 | that gets you really close to your objectives.

00:56:19.380 | - Josh, thank you so much for your time today.

00:56:21.380 | I really appreciate the insight

00:56:22.860 | and I really appreciate what everything that you

00:56:25.580 | and your team do for us all at Vanguard.

00:56:29.180 | - Oh, thanks Rick.

00:56:30.020 | It's been great.

00:56:31.380 | - This concludes this edition of "Bogleheads on Investing."

00:56:34.300 | Join us each month as we interview a new guest.

00:56:37.220 | In the meantime, visit boglecenter.net, bogleheads.org,

00:56:41.460 | the Bogleheads Wiki, Bogleheads Twitter.

00:56:43.940 | Listen live each week to "Bogleheads Live"

00:56:46.220 | on Twitter Spaces, the Bogleheads YouTube channel,

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00:56:51.860 | Join one of your local Bogleheads chapters

00:56:54.740 | and get others to join.

00:56:56.100 | Thanks for listening.

00:56:57.140 | (upbeat music)

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Bogleheads® on Investing Podcast 045: Nick Gendron, Josh Barrickman on Total Bond Market Index Funds

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