4 Top Vanguard Bond Funds

From its bond index funds to its actively managed funds, Vanguard's low-cost fund choices rank as some of the very best bond funds on the market today. The following Vanguard funds list contains some of its best bond funds, with the short case for each fund below.

Data source: Vanguard.

Total Bond Market Index Fund

The Vanguard Total Bond Market Index Fund does exactly what it sounds like: It offers broad, diversified exposure across more than 8,300 different bonds in the portfolio. The fund seeks to track the Barclays U.S. Aggregate Float Adjusted Index, which tracks a wide assortment of government and corporate bonds, as well as mortgage-backed securities that have at least one year to maturity.

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This is a very "safe" bond fund, as it does not venture into to lower-rated junk bonds, which offer higher yields at a higher risk of capital loss. Because it aims to track the vast majority of the bond universe just as total stock market funds seek to track the performance of virtually all stocks, it is predominately invested in government bonds. All in all, just over 64% of its assets were invested in government bonds and government mortgage-backed securities at the time of writing.

It is also fairly protected from interest rate risk. When interest rates rise, bond prices fall. When interest rates fall, bond prices rise. The fund's holdings have an average duration of just six years, and thus a 1% increase in interest rates would result in a 6% decline in the fund's value. Conversely, a 1% decline in interest rates would lead to a 6% gain in the fund's value. Duration is one of the best ways to estimate the risk of loss from interest rate fluctuations for individual bonds as well as bond funds.

All in all, this fund could be a great "core" holding, given its broad diversity, limited credit and interest rate risk, and its minuscule expense ratio of just 0.16% of assets. The fund's current yield of about 1.8% certainly isn't exceptional, but it's reflective of the fund's lower-risk investment portfolio.

Vanguard Long-Term Bond Index Fund

To get higher returns from bonds, you have to accept more risk, either interest rate risk or credit risk. This fund lets you take more interest rate risk for higher returns by investing in bonds that have at least 10 years to maturity.

The fund currently holds more than 2,000 individual bonds, but is most concentrated in bonds that are issued or guaranteed by the U.S. government. U.S. government bonds make up about 40% of assets at the time of writing, and it completely avoids junk bonds, which reduces the risk of defaults and resulting capital losses.

Interest rate risk is significant with this fund, however. The fund's portfolio had an average duration of 15.7 years, which tells us that each fluctuation in interest rates will result in significant gains or losses for the fund. Taking this extra risk does result in extra income, however, as the fund has an SEC yield of about 3.2%, nearly 80% more than the Total Bond Market Index Fund.

Inexpensive to buy and hold -- the fund carries an expense ratio of just 0.16% -- it would be a fine investment for those who aren't all that concerned about rising interest rates going forward.

Vanguard Short-Term Corporate Bond Index Fund

This bond fund generates slightly higher returns by investing in investment-grade corporate bonds. It also takes less interest rate risk, as it only invests in bonds issued by industrial, utility, and financial companies with maturities of 1 to 5 years. This fund seeks to track the Barclays U.S. 1-5 Year Corporate Bond Index, which excludes lower-yielding government bonds.

The fund's 1.7% current yield has to be balanced with its lower-risk portfolio. The fund is light on interest rate risk, as its average holding has duration of just 2.8 years. Thus, an increase in rates of 1 percentage point would lead to a decline of about 2.8% for the fund, while a decrease in rates of 1 percentage point would push the fund up by about 2.8%. 

The fund's focus on highly rated corporate bonds with low duration makes it a good low-risk pick to offset the higher risks of a stock portfolio. The biggest downside is that it may be inaccessible to smaller investors, given its $10,000 minimum investment in the form of Admiral shares.

Vanguard High-Yield Corporate Fund

This fund is the only actively managed fund on this list, managed by Wellington Management Company, which manages many of Vanguard's actively managed mutual funds.

This fund held 469 bonds at the time of writing, and had a mandate to invest at least 80% of its assets in corporate bonds that have a junk bond rating or lower (a rating below Baa by Moody's). The fund is primarily in the business of taking credit risk to earn higher returns, which can result in very volatile performance in times of market stress and economic weakness. Notably, the fund lost 21.3% of its value in 2008, and returned 39.1% in 2009. This is not a "widows and orphans" type of bond fund.

Relative to other junk bond funds, it isn't especially speculative. The fund invests more in higher-quality junk issuers than the SPDR Barclays High Yield Bond ETF, a popular junk bond ETF. Morningstar data show the SPDR ETF invests twice as much of its assets in below-B-rated bonds as the Vanguard fund does (15.4% vs. 7.4%). Vanguard's fund also holds far more BB bonds, which are just one step removed from an investment-grade rating of BBB.

The fund's yield of about 5% is obviously very attractive to yield-starved investors, but it should be weighed against the fund's significantly higher risk of capital loss. This fund won't provide many of the benefits of diversifying into bonds (namely, capital preservation) in downturns, and shouldn't be used as a higher-yielding substitute for safer investment-grade bond funds. But for a yield enhancement to a diversified portfolio, the fund's low expense ratio and active management makes it one of the best choices in the world of junk bonds.