Which Short-Term Bond Mutual Fund Should You Use For Your Fixed Income Asset Allocation in Taxable and Tax-Sheltered Accounts?

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As I discussed in a post last week where I analyzed intermediate- and long- vs. short-term bonds, I determined that the stability that short-term bond offered made them better suited for my personal investment needs. This was my conclusion in spite of the significant finding that intermediate-term bonds are in fact more efficient in terms of the risk-adjusted return provided.

Having determined that short-term bond funds are best suited for my needs, the question then becomes, “What is the best specific type of short-term bond fund for my needs?”

Seeking out an answer to this question will be the topic of today’s post. Let’s get started!

What Short-Term Bond Mutual Fund Options are Available?

Since my experience has shown that no one is able to consistently beat Vanguard when it comes to low-cost investing, I will focus my screening to the funds that Vanguard offers.

A quick search through the Vanguard database reveals the following short-term maturity bond mutual funds on offer (all credit qualities shown):

• Limited-Term Tax-Exempt, Ticker Symbol VMLTX
• Short-Term Tax-Exempt, Ticker Symbol VWSTX
• Short-Term Bond Index, Ticker Symbol VBISX
• Short-Term Federal, Ticker Symbol VSGBX
• Short-Term Investment-Grade, Ticker Symbol VFSTX
• Short-Term Treasury, Ticker Symbol VFISX

Since the purpose of my fixed income asset allocation is STABILITY, I am not interested in holding anything but the highest credit quality bonds. This restriction removes the Short-Term Investment Grade fund from the list of eligible options, leaving the 5 options shown below:

• Limited-Term Tax-Exempt, Ticker Symbol VMLTX
• Short-Term Tax-Exempt, Ticker Symbol VWSTX
• Short-Term Bond Index, Ticker Symbol VBISX
• Short-Term Federal, Ticker Symbol VSGBX
• Short-Term Treasury, Ticker Symbol VFISX

A Look Inside the Short-Term Bond Fund Options

In my experience, a highly valuable, yet often overlooked type of analysis is to simply read IN DETAIL about what a mutual fund actually holds. It’s so simple because this information is freely available from the fund provider’s website and/or fund prospectus, yet often, I’ve found investors (I am even guilty of this I admit) don’t take the time to really understand a mutual fund before investing in it.

As such, listed below is a look inside each of the short-term bond fund options:

• Limited-Term Tax-Exempt, Ticker Symbol VMLTX
• Invests in short-term, high-credit quality (AA and AAA) municipal bonds with a maturity around 2+ years.
• 90% municipal bonds
• 8% cash
• Average bond holdings maturity = 2.6 years. 
• Short-Term Tax-Exempt, Ticker Symbol VWSTX
• Invests in very short-term, high-credit quality (AA and AAA) municipal bonds with a maturity between 1-2 years.
• 85% municipal bonds
• 15% cash
• Average bond holdings maturity = 1.3 years. 
• Short-Term Bond Index, Ticker Symbol VBISX
• Passively managed index fund that holds representative bonds in such a way that it tracks the Barclays US 1-5 year government/corporate bond index (short-term investment grade US bond market).
• Average bond holdings maturity = 2.8 years. 
• Invests in short-maturity U.S. Treasury, agency, and investment-grade corporate securities. Listed below are the major category percentages.
• 62% Treasury
• 8% US agency
• 21% corporate bonds
• 2% cash
• 0.2% mortgage backed securities
• 7% other government securities
• Short-Term Federal, Ticker Symbol VSGBX
• Fund that holds short-term bonds issued either directly by the government in the form of Treasury bills or by federal agencies. Listed below are the major category percentages.
• 7.5% Treasury
• 72% US agency
• 10% mortgage backed securities
• 11% cash
• Average bond holdings maturity = 2.3 years.
• Short-Term Treasury, Ticker Symbol VFISX
• Fund that invests in almost exclusively (99.99%) short-term maturity Treasury Bills issued by the US government.
• Average bond holdings maturity = 2.3 years. 
• Has essentially zero credit risk since T-Bills are backed by full faith and credit of the US government.

Just by reading through this information, there are a couple potential red flags (highlighted in red text above) in the structure of the Short-Term Federal and Short-Term Tax Exempt Funds that could make these unattractive to me.

• With the Short-Term Tax Exempt Fund: 
• The average maturity is only 1.3 years, which is a little shorter than I would like for someone with a long term investing focus like I have. 
• In addition, the fund holds a fairly large position in cash (15%). This often can be a sign that the fund has to keep a lot of cash on hand to handle redemptions of investors pulling their money out. 

• With the Short-Term Federal Fund:
• The most significant issue, in my opinion, is the lack of exposure to US Treasury securities (only 7.5%). 
• Instead, the fund is overweighted in US agency and mortgage-backed securities, which can cause an unnecessary increase in exposure to risk. 

What Do the Experts Say About the Type of Short-Term Bonds to Use?

Short-Term Bond Fund Options as a 1-Component Portfolio

Having taken a look at the advice given in the literature about which type of short-term bonds to hold in one’s fixed income allocation, I then wanted to do some of my own analysis and number crunching to see how things looked for myself over a time scale I could control.

To do this, I went to Yahoo Finance (the site where I always get my historical pricing data) and downloaded the historical price information for the five Vanguard bond mutual funds investigated above.

Whenever I do these types of back-test analyses, I generally like to pick the longest time period I can get access to. In this case, the historical pricing data only went by 16.75 years, to 1996. Therefore, the time period I chose for the analysis was 1996-2013 (present).

First, I wanted to analyze the pure fluctuations/growth of the individual mutual funds (1-component portfolios) over the time period. To do this, I simulated the growth of a $10,000 initial investment in 1996 in each of these funds.

The graph below shows the overall results, where the dark blue line = Vanguard Short-Term Treasury Fund, the red line = Vanguard Short-Term Bond Index Fund, the green line = Vanguard Short-Term Federal Fund, the purple line = Vanguard Short-Term Tax Exempt Fund, and the light blue line = Vanguard Limited-Term Tax Exempt Fund.

Just by inspecting the graph above, there are a couple interesting observations that can be seen:

• As expected, the tax-exempt municipal bond funds featured a lower return over the ~17 year holding period, since the returns are tax-free.
• It is interesting to note that the performance of the Short-Term Treasury, Bond Index, and Federal Funds only really started to diverge in the past 5 years or so since the market downturn in 2008-2009. 

Short-Term Bond Fund Options in a 2-Component Portfolio

While examining the “personality” of an asset class in the isolation of a 1-component portfolio is interesting, an even more important thing to look at is how the fund will perform when mixed in as part of an investor’s real life asset allocation.

To investigate this activity, I simulated the growth of the same $10,000 initial investment from 1996-2013 (present) using a 70% Vanguard S&P500 Index Fund equity allocation and 30% fixed income allocation utilizing either of the 5 Vanguard Short-Term Bond Funds mentioned above.

The growth of the $10,000 initial investment in the various 70/30 2-component equity/fixed income portfolios can be seen in the graph below, where the dark blue line = using the Vanguard Short-Term Treasury Fund, the red line = using the Vanguard Short-Term Bond Index Fund, the green line = using the Vanguard Short-Term Federal Fund, the purple line = using the Vanguard Short-Term Tax Exempt Fund, and the light blue line = using the Vanguard Limited-Term Tax Exempt Fund. For reference, I have also included the growth that would have occurred if the Vanguard S&P500 Index Fund was used by itself (100% equity, no fixed income – orange line).

Although this graph is somewhat “pretty” to look at, I’m afraid it doesn’t tell us all that much, with the exception that incorporating the Vanguard Short-Term Treasury, Bond Index, and Federal Fund essentially results in the same performance over the time period utilizing a 70/30% equity/fixed income asset allocation.

In this case, I think that looking at the return data during this 17 year time period provides a much more interesting perspective (shown in table below).

Indeed, when we inspect the data in the table above, we see that there is really not that much of a difference between utilizing the three nominal (non tax-exempt) Vanguard bond funds for the fixed income portion of your portfolio. Essentially, this tells us that any of these choices would be fine, and that it is just up to personal preference.

As expected from the 1-component analysis previously, utilizing the Short-Term Bond Index in a 70/30 asset allocation portfolio yields on marginally higher average annual return, but in fact gives the same overall return as using the Short-Term Federal Fund.

It is also quite interesting to see that incorporating the Short-Term Federal Fund yields 1.3% decrease in risk/standard deviation, but only at the cost of a 0.26% decrease in average annual return. What this indicates is that the Short-Term Federal Fund is slightly less correlated with the returns of the S&P500 than the Short-Term Bond Index Fund. This possibly could stem from the fact that the Short Term Bond Index Fund holds 20% corporate bonds, which would likely be more highly correlated with the performance of corporate equity (i.e. the S&P500).

Conclusion from 2-Component Portfolios – From the 2-component portfolio analysis above, we see that there is not a HUGE difference between utilizing any of the three nominal Vanguard bond funds for your fixed income allocation (decision would likely come down to personal preference). However, it was found that the most efficient tool at providing the highest risk-adjusted return was the Short-Term Federal Fund. 

Note: If you want to view all of the details of the calculations I used for the 1 and 2 component portfolio back tests, click here to download a copy of the Google Docs Spreadsheet.

Which Short-Term Bond Fund is Best for Taxable Accounts, Specifically?

Thus far, I have somewhat ignored the use of tax-exempt bond funds because of their lower pre-tax returns compared to the 3 nominal bond funds. Indeed, for investors that are focusing on their tax-sheltered accounts, there is no reason to invest in tax-exempt bond funds. 

However, the decision is not so simple for investors that are placing money in their after-tax accounts since you need to take in to consideration your current tax bracket.

• The general advice given by books such as The Only Guide You’ll Ever Need for the Right Financial Plan is that it is better to hold tax-exempt over nominal bonds in taxable accounts for all investors that are not in the lowest (15% tax bracket). 

While this is a good rule of thumb, let’s see how it stacks up with our numbers from the 1-component portfolio analysis above:

• To do this, we’ll compare the average annual returns of the Short-Term Bond Index (nominal – subject to federal and state income taxes) and Limited-Term Tax Exempt Funds (exempt from federal but not state income taxes). 
• The Limited-Term Tax Exempt Fund was chosen as the tax-exempt bond fund of choice since it is more efficient in a 2-component portfolio setting than the Short-Term Tax Exempt Fund. 
• For the sake of simplicity, we will assume a constant 7% state income tax rate.
• Short-Term Bond Index Fund:
• Average pre-tax annual return = 4.96%.
• – Minus 7% state income tax = 4.61%.
• – Minus 15% federal income tax (my current tax bracket) = 3.92%.
• For comparison reasons, if your federal tax bracket had been higher at 25%, the federal + state income tax adjusted return would = 3.46%.
• Limited-Term Bond Index Fund:
• Average pre-tax annual return = 3.78%.
• – Minus 7% state income tax = 3.52%.

As we can clearly see here, the general rule of thumb mentioned above was indeed correct. Taxable fixed income money should be invested in the Limited-Term Tax Exempt (Municipal) Bond Fund unless an investor (like I am) is in the lowest, 15% tax bracket.

For investors like me with low income, I am better off investing in nominal bond funds in my taxable account (at least for the time being until my income goes up after graduate school).

CONCLUSIONS, MY CURRENT Short-Term FIXED INCOME ALLOCATION, AND PATH FORWARD

So, after going through all of this investigation comparing 5 short-term bond options, what’s the overall verdict? Well, I think it can be summed up in a couple lines: