 Welcome everyone to Bogle Heads On Investing, episode number 45. Today our discussion is on the Total Bond Market Index Fund and we have two special guests, Nick Gendron, Global Head of Fixed Income Index Product Management at Bloomberg and Josh Barwickman, Principal and Head of Fixed Income Index Investing at Vanguard. Hi everyone, my name is Rick Ferri and I'm the host of Bogle Heads On Investing. This episode, as with all episodes, is brought to you by the John C. Bogle Center for Financial Literacy, a 501-C3 non-profit organization that you could find at BogleCenter.net. And before we get started with this episode, I have a public announcement. Tickets for the Bogle Heads Conference have gone on sale. You can find information on BogleCenter.net and BogleHeads.org. The conference will take place in a suburb of Chicago on October 12th through the 14th. It is a non-commercial conference. There are no sponsors. There is no commercialism. No one is going to try to sell you anything. It's pure investment education. I'm looking forward to seeing you there. In this 45th episode of Bogle Heads On Investing, we're discussing total bond market investing, also called aggregate bond market investing. And I have two special guests. My first guest is Nick Gendron. He is the Global Head of Fixed Income Index Product Management at Bloomberg. Nick's team creates the Bloomberg Aggregate Bond Market Index, which is the index that total bond market index bonds follow. The next guest is Josh Barwickman. He is a principal and head of Fixed Income Indexing at Vanguard. Josh's team are portfolio managers. They take the index that Bloomberg puts together and they have to create a real live working portfolio out of it. And that's quite a challenge. We're going to start first with Nick and then we're going to move on to Josh. So with no further ado, let me introduce Nick Gendron. Welcome to the Bogle Heads On Investing podcast, Nick. Thank you very much, Rick. Appreciate it and really happy to be here with you. Well, thanks. You are the first guest on our podcast today and your job is to create the fixed income indexes that are used for index fund tracking. Before we get moving here and talking about total market index or the aggregate bond market index, which is going to be our main focus today, tell us a little bit about your background and how you got to be the head of Fixed Income Index Product Management for Bloomberg. Yeah, sure. I'm happy to share that. I actually joined Lehman Brothers a few years after I got out of college. I was going for my MBA back then and they were really looking for people to come in and help them as they were starting to really build an index business, just come in and help with client support around indices. They were starting to get a lot of questions around what they were doing and Lehman Brothers was certainly a big bond shop. It made sense that they were producing these types of indices to share with the marketplace. I really came in in a more of a client support role. Didn't know much about bonds at the time, but was looking for a change of career and they gave that to me. The rest was history. I just kept moving through the system. We did a lot of portfolio strategy work for clients with our indices, et cetera. We learned all sorts of risk analytics and provided those to the marketplace as well. Ultimately, evolved into Barclays once Lehman went under in 2008. Then Bloomberg bought our franchise from Barclays in August of 2016. I've been at Bloomberg for about the past five and a half years. If I hold that up, you have been involved in Fixed Income Indexing for 30 years as of next month, correct? That is correct. We're coming right up on the 30-year anniversary, which is really hard to believe. It's definitely been an exciting run. It's kept me in the business because the business just keeps changing and the needs of investors keep changing. It's definitely not a rinse and repeat type industry. There's always innovation needed and lots of interesting client conversations to have. Originally, when you went to Lehman for others, the number of index funds out there were fairly limited. The purpose of the indices that you were running were more for benchmarking. Can you describe the difference between indexes for a benchmark versus index for an investable product? Many clients use our indices for what we call just benchmarking. For just standard benchmarking, clients, they really need a home base or a foundation from which to make investment decisions. If they use the US Ag, for instance, as a benchmark, that's what is considered market neutral. For them to prove that they can use their investment prowess, if you will, to add value, that's a great place to compare yourself to if the US Ag is truly meant to be a market neutral representation of the universe. We do have many clients that just use that to compare themselves to and manage their risk to that benchmark each day while hopefully showing out performance from a passive side of things. Certainly most ETFs, if you will, and many mutual funds and many institutional funds really try to track the index exactly by the basis point almost in fixed income. So it's a, it really is a difference between passive versus active. It's interesting that a lot of the index fund managers use the term total bond market for the aggregate US aggregate bond market index. A Barclays doesn't use that term total bond market because it's not the total bond market. So could you explain what is the US aggregate bond market? Yeah. I mean, in some ways, Rick, it's intended to be the total of some bond market. But the question is what, what bond market is it supposed to be? And in the case of the US aggregate, it's really designed to be a representation of what I would call the core investment grade US dollar denominated. So if you're in the US any US dollar bond, but again, the key thing is core investment grade US dollar denominated. And then we have to give it a name, right? And US AG has been sort of the trademark name for a long time. And it's become a flagship name in the industry. Again, we could have at some point in time way back when decided, Hey, we're going to call this the total bond market index. But we decided, no, US AG is a better name. And again, total bond market to me would be every bond out there, you know, it could be any asset class, it could be any currency denomination, etc. So again, it really depends on the market that you're talking about. Now it's interesting because it really there's a lot of types of bonds, US bonds that are not in the US aggregate index, which is the basis for total bond market index funds. The one that jumps out is tips, Treasury inflation protected securities. Gosh, I mean, this seems to be such a natural fit for a total bond market index fund. But yeah, it's not in the aggregate index. So why don't you start with that and kind of go down the list? You've probably a very interesting dynamic when tips were started to be issued in 1997. And the reason I remember that exact date is just because that was actually the birth, if you will, of what we call our index advisory councils, which became more formal meetings with with our major index users to get feedback on how we evolve the methodology within our indices. But tips was a huge debate back then. Our inclination when tips were issued was to put them in the US Act. There were many investors and many that disagreed with that sentiment that inflation itself is really should be a separate asset class, and doesn't belong in that the true spirit of a traditional fixed income investment. So there was a debate. And if you went around the industry today, you'd still probably get several investors who would think that tips should be part of the US Act. But that's some of the interesting part of being an index provider is investors don't always agree on everything. The bond market, you know, has a lot of different factors, a lot of different types of securities that are out there. And we have to work to try to synthesize all that feedback, if you will, into what we feel should be in the US Act. So that there was actually a real good debate about it. And it's it's something that we've brought up over the years with our index councils. 1997 wasn't the only time. But still as of today, tips are not part of the benchmark. And this is an investment grade index. So there's no high yield, no high yield, completely separate high yield index. And the definition of ag for us is investment grade is one of the keys. You know, we have what's called a global ag to which spends 28 currencies, but it's all investment grade. So again, separate indices for high yield for emerging markets, you know, municipals, inflation, etc. The ag part of it, the investment grade part of the bond market is by far the largest component. And ironically, something that is in the index, which a lot of people don't know, are what are called Yankee bonds, which are foreign bonds. Yep. Yankee bonds are an interesting dynamic. There are a lot of non US institutions, or government bodies, what have you that issue US dollar denominated securities. So just a little research on this. There's actually in the US ag, there's 1400 securities that are Yankee bonds, almost 2 trillion of the indexes in Yankee bonds. So you say, Okay, well, who are those issuers? Many of them are these supranational institutions, IBRD, which is International Bank of Reconstruction and Development, EIB, European Investment Bank, ADB, Asia Development Bank. So there's these supranationals that issue a lot of debt and most of it is in US dollars. So those go in the US ag, their investment grade debt, but yeah, they're they're non governments like Mexico, Peru, Philippines all issue investment grade debt in US dollars, that's in the US ag. It's an interesting component of the market. Canadian provinces issue US dollar denominated debt. So those are some examples of Yankee bonds. There's certainly other government bodies that issue US dollar denominated bonds as well that are what are called 144 A's or they're not SEC registered bonds. And that's another rule of the US ag, they have to be SEC registered. So Saudi or Indonesia, they issue US dollar denominated debt as well, but it is in 144 A form. So that does not go into the US aggregate index. It's these are just some of the rules that have been in place for a while. And we revisit them every so often. But that's how we stand today. What would you say the percentage of the US aggregate index is in Yankee bonds? So I guess it's just a matter of the maths, pretty easy to figure out if the US ag is about 25 trillion in size and Yankees are 2 trillion of that. Oh, about 8% almost. Yeah. Yeah. And you know, it's funny because a lot of people say, oh, we need to invest in the US bond market, and we need to invest in foreign bonds. And I tell people, well, I mean, the US total bond market index funds already have this 8% already in foreign bonds. And they're shocked at that. Yeah. Let me ask about US strips, zero coupons. In the US aggregate index, one of the rules is that it has to be a fixed rate coupon. It can't be a variable rate coupon. It has to be fixed rate. Do you consider zero coupon bonds to be fixed rate bonds? That's that's a good question. My answer to that would be yes, as long as they're originally issued as zero coupons. So US treasuries are stripped from from normal bonds. So we we include the normal bonds in in the index. We don't want to create sort of stripped out versions of those bonds or something that would be cause us to double count those securities. So we just take the the the outstanding amount of the originally issued security. And that's what goes into the index. Let's talk about mortgages, because you get the pure mortgage, and then you've got double lateralized mortgage obligations, packaged mortgages, if you will, tranches and so forth. So it would be double counting if you had both of these in. So which one do you count? It's just the straight mortgage pools that are that are issued. We don't have CMOs in the index. But what we do is we take all of the residential mortgages as issued as pools, and then aggregate those into into the index. And as of today, there's about, I think it's about 2526% of the index is in mortgages. And these mortgages are government backed only? Yeah, or agency backed. So they're backed by the three agencies, Ginny May, Freddie Mac, and Fannie Mae, you know, we're tracking 30 year issuance, 15 year issuance, 20 year issuance, really the where the market is most concentrated. And certainly there's, again, this is really where the bulk of the mortgage market is today. And over time, as of today, again, in what we call our US ag or, you know, sort of the core universe, it's only those residential mortgages backed by those agencies. So you've been around for 30 years now in this bond indexing business. And you have seen something like the US aggregate index shift, not only does it shift in composition as more mortgages versus corporates or treasuries are created, the sectors get bigger and smaller. And how is the index shifting? How has it shifted? And how is it shifting? Yeah, again, Rick, what we're doing every month, basically, just a quick background, every month, we have a set of rules for what bonds go into the index and which don't. And every month that's a monthly rebalancing every month we go out, we capture the bonds that meet the rules, and we rebalance the index. So, you know, it's very unique. It's very different from stock indices, right? We are there's bonds issued all the time. So we want to keep, keep current with with what the market looks like. And that's, you know, that's similar to other, how other competitor indices do it as well, monthly rebalancing is, is fairly standard in the industry. But what that does is it incorporates and continues to show as issuance patterns differ and as mortgages pay down and as corporations come in and out of the market to issue bonds, what our index is doing is just reflecting the updated reality of the situation. So a good example, how is how have the sectors changed over the years? Well, if I look at US Treasuries, for instance, today, US Treasuries are about 39% of the overall index. But they've been as low as 22% down in 2002. They've been as high as almost 50% in 1985. They're sort of at one of the higher points that they've been in a little while. But it just is totally fluctuated based on how the US Treasury is deciding to issue debt, and then what maturities and in what size, right? And we just reflect that reality as the market just sort of evolves. And, you know, that whole evolution takes place. So it's kind of an interesting part of it. You don't really see it month to month. But if you look at over long periods of time, you'll see the trends. And the interesting in the bond market, which is different than the stock market is that the stock market is set by buyers and sellers. So you the stocks you like, like Google and Apple, more buyers, price of the stock goes up, it becomes a greater percentage of the index because of demand, if you will, from the marketplace, buying, buying more stock and pushing the valuations of these companies up. But that's not really what happens in the bond market. In the bond market, it's how much the issue was issue that determined the sector allocation. So it is quite different. It's market value weighted. So price, you know, the price of a bond as it goes up, it will contribute a bit more. But it's really the main bulk of the percent weight of that bond is going to be how much it has issued in debt. You know, we are market value weighting each bond in the index. So price does factor in. But again, I think, as you said, it's the amount outstanding of the bond times the price. And there's a crude value in there too for a market value, but which sets the weight of a bond in the index. So this year, 2022, we've seen interest rates move higher. And the value of fixed income across the board has moved down because of that. And this function is called duration. So we can measure how much it's going to move down, the prices move down based on how much interest rates move up. Can you, number one, speak about duration and then talk about how duration changes. If interest rates are very low, there is higher duration when interest rates are very low, and there's lower duration when interest rates are very high. Could you explain the whole concept of duration and how it moves? Sure. With the US ag, it's interesting because government and credit or corporate portions of it are what you call all positively convex bonds. But the mortgage piece of it reacts actually the complete opposite way. So I'll go through that dynamic. But the duration of the index definitely fluctuates with the interest rate environment. It tends to be because the US ag is about a third in mortgages. It's a little less than that. It's probably a quarter mortgages now, but over the course of time, it's been about a third. When rates move in a certain direction, mortgages are very, very volatile with respect to their durations because if you get into higher interest rate environments like we are today, even though we're not at that peak point, the mortgage duration is completely dependent on what type of prepayments are expected in the marketplace because they're all callable securities. If rates go low, obviously everybody's going to pay down their mortgages and try to lock in a lower rate, and therefore the existing mortgages in the index are all going to pay down and new ones are going to be issued. And so that their duration can get quite low in low interest rate environments and higher interest rate environments as we've moved up recently. The duration of the mortgage sector is about in the fives right now 5.5 if I'm not mistaken, it got as low as less than a year back in 2008 at the financial crisis when their rates were really dropping and homeowners were finding money very cheap and refinancing, et cetera. So you were basically saying that when the duration was less than a year that it's just a big huge turnover in the mortgage market, people were refinancing. And now that interest rates have moved up a lot less as that is going on. So people are holding on to their mortgages and makes the maturity, if you will, of the bond much further out, much further out, much more exposed to interest rate risk, right? And in duration, as you mentioned, is really how prices are going to respond to interest rate moves. So it's all interest rate risk. That's the main risk that almost every fixed income investor is worried about is what's the duration of the index? What's the duration of my portfolio? If you are mismatched there, and everybody knows it's tough to time duration or tough to time interest rates, you can really get on the right side of that and do very well. But if you're on the wrong side of it, that's going to be your main reason why you've underperformed in fixed income. So if we look at the duration of how it's drifted over time, the US Ag was down at about three and a half years down at that heart of the financial crisis, as I mentioned in 2008, because mortgages were so low in duration, but it's now at 6.6. So an investment in the US Ag gets you a duration of 6.6. And like you said, we've not had worse performance in the bond market in 40 years. The first quarter of the US Ag, we're down almost 6%. It was the worst quarter since 1980. So it's 40 years since the bond market has performed this poorly. The US Ag has generated negative returns in seven out of the last eight months, which is unheard of in fixed income. So it'll have a tendency to really write the ship. It's supposed to be a fairly stable investment. But when rates move directionally like this for extended period of time, which we have not seen for a long time, it hits every part of the bond market. You can look at every asset class, not just US Ag, whether it's high yield, whether it's global bonds, whether it's emerging markets, and we all want to know what Russia did to that situation. But it's been a tough quarter for fixed income investing. So we've talked about duration and duration as a measure of interest rate risk. And the fact is, when interest rates go up, the duration of mortgages goes up. But the duration of coupon bonds like treasuries actually goes down, correct? You kind of know how much a regular bond is going to move as far as duration just based on mathematical calculation of a bond. And they'll move, but not as significantly as a mortgage back. And the thing with the mortgage back securities is they're dependent on the prepayment model you're using as well. So you can argue over what the duration of a mortgage back security is based on, you know, we've got a great prepayment modeling team here at Bloomberg. But if you look at a rival index provider, it's going to say the duration of the mortgage universe is different than what we say is. Well, let's talk about that. Because really, in a way, you're talking about how do you price bonds? And we know that a lot of the bonds in the US aggregate, in fact, all bonds, all bond indices have bonds that don't trade, unlike stocks, a lot of the fixed income doesn't trade. So these models are pricing the bonds, correct? And so you have to actually price each bond every day, even though it's not trading? That's right. So, you know, there's different price providers we've used over the years. Our what's called our deval team here at Bloomberg is Bloomberg's pricing service. And they provide all the pricing for the bonds in the index prior to us joining Bloomberg, we use the combination of vendor pricing, but a lot of it came from our Barclays or Lehman traders who were trading the bonds all the time. And we did have a pricing team back then, which would work with them and price the index. So the pricing of the index has has evolved over time. And now we're using pure VVAL prices. They do a great job of pricing the universe, but you're right. For the bonds that you are able to see, you know, trades on every day, or bids or offers on every day, you can you can price those very, very well. Part of the universe does have to be model price, like if a bond of a certain issuer, if you can price that one fairly well, but the other one doesn't trade, you're going to have to deduce sort of a movement of that bond or what's called the spread of that corporate bond relative to treasuries fairly in line with how the how the bond of the how the other bond of that issuer moved. There's other ways to model bonds as well as bonds of a similar quality industry, that type of thing. But universes like treasuries are very easy and liquid and you could come up with really, really quality prices. And for most of the bonds in the index, you could you could definitely have observations for but others you're going to have to model price for sure. Now the index funds themselves, the ones who are managing the index funds, they also have to price their portfolios on a daily basis. And some of the bonds in those portfolios may not trade on a daily basis. So are they using the same pricing or is there some discrepancy between what they're using and what you're using? Yeah, that's that's a great question, and probably a great one for Josh as well. But yeah, they have to use services or pricing services to price their portfolios. In some cases, they will use B Val because they believe in the quality of those prices and they will be and they'll use B Val not every client does. There's many other competitor pricing services out there that do a good job. And clients use who they feel are the right pricing vendor for them. But you're right in the saying that if if an investor is using a different pricing service than the index, you could be exactly matched on every constituent of the index but still show different performance than the index because of the difference in pricing services. So, you know, it's not an exact science, that's for sure. So, you will have some tracking error because of that. So, last question and we'll wrap it up and this has to do with derivatives, if you will, off the US aggregate and I know that Vanguard uses a float adjusted. As far as the float adjusted index, there's there's bonds in the market that are held by the Fed and and certainly as part of the financial crisis, the feds always bought treasuries and and just in all transparency, those have always been excluded from the US Ag from day one. That's just part of our methodology because it was a very consistent pattern and it's it's been baked in as part of the methodology forever. So, the amount of treasuries in the float adjusted and in the standard US Ag are exactly the same. Okay. The mortgages though were another debate back in 2009, once the feds started buying mortgages, should we take them out of the index or should we keep them in because they had never been in the game before. Back then, nobody knew how long it was going to last nor did we actually have the information at a QCIP level, especially early on to start taking them out. We can't just guess over the course of time and the the information became more transparent. But when we were trying to make a decision about what should we do with all this with the Fed holdings of MBS, there was again a lot of good conversation with this about our clients due to the uncertainty of how long the Fed was going to be in the game, should we take out all the bonds and then have to put them back in and that type of thing. There's a lot of good good points brought up. So, that's how the float adjusted version of the U.S. AG was was born was the main differences than the amount of mortgages in the two indices. So, if I could give you a couple stats, it's the mortgage part of the index. Our U.S. AG has about 30 percent in securitized and that's mortgages plus only a small portion of ABS and CMBS. The float adjusted AG has 22.3. So, we're almost seven and a half percent less in terms of securitized debt in the float adjusted index and that means the other sectors just go up a scaled amount. So, there's more there's basically more corporate bonds in in the float adjusted AG and there's more treasury bonds in the float adjusted AG. So, which one outperformed this last quarter? I looked at that and the difference was only seven basis points. Oh, is that all there was? Okay. It's really it was really minor now. Again, I haven't done all the attribution on it but as of right now the difference in you would think the different the duration of the because we've talked about mortgages being at their highest duration in a while but the the curious part is the duration of the other components is higher than the the overall duration of the U.S. AG. So, even though securitized or mortgages at their highest in a while it's still not the same duration as the other components. So, that being said the float adjusted index is about 0.15 years longer in duration than the standard U.S. AG is right now. So, not much not much. Well, Nick it's been extremely educational. Thank you so much for being on Bogleheads on Investing and we greatly appreciate all of the insights and good luck with the the next 30 years in this industry. Really appreciate you having me on today and look forward to speaking with you soon. Our next guest is Joshua Barakman, Principal and Head of Fixed Income Index Investing at Vanguard. So, let me introduce Josh Barakman. Welcome to Bogleheads on Investing Josh. Thanks for having me. Josh, you've been at Vanguard since 1998 and now you're the head of bond indexing managing about a trillion dollars in assets. So, it's a big responsibility but before we jump into bond index funds and the total bond market index fund could you tell us a little bit about yourself a little about your background how did you get into this position? Yeah, sure happy to. So, I grew up in Ohio and I went to school out there studied finance made my way east to go to business school and started up with Vanguard in 1998 in one of our tax departments did that for about 12 months and got an opportunity at that point to move to the fixed income group as a trader for our municipal bond funds so was able to do that for three years trading various different asset classes within municipals and then in 2002 had the opportunity to move over to our fixed income index team to the time was was a rather small team you know maybe eight folks total but a really great opportunity for me coming up to really get to work with some luminaries in the field of indexing folks like Ken Volper, Craig Davis, Chris Alwine was able to grow my career on the index desk various roles as trader portfolio manager across a lot of different asset classes then in 2013 took over as head of the desk and have really been in that role ever since you know the index desk in particular has been really a dynamic place to work and have a career just with just the amount of different markets that we've banded into ETFs kind of list goes on and on in terms of how the business has grown and changed over the time I've been there so it's been a great place to have a career. How many different funds are you responsible for managing both the US and internationally? Yeah so the global footprint for for bond index is around you know 80 85 different mandates that kind of depends how you classify certain things but yeah about 85 mandates and just around a trillion dollars in AUM. And how much of that is US versus outside the US? Yeah the bulk of it is definitely in the US you know I would say the breakdown is probably around 80-20. And the flagship product in the US is the total bond market all share classes? That's right. And by the way you have different total bond markets correct you have the total bond market one you have the total bond market two you have total bond market ETF how many different total bond market funds either? There's really two there's total bond market and total bond market two the ETF you can really think of as an extension or different share class within total bond market one it's really just a share class of that fund. There's the total bond market two product which is really in place to serve as the bond option for some of our multi-asset strategies. Is there any difference between how they're managed? No they're going to be pretty close to one another in terms of overall strategy and composition for different reasons for cash flows and things like that you will have some deviations but we're talking very much at the margin. Well I have some question about if one fund one bond index fund total bond market index fund needs a bond and total bond market index fund number two has a bond is it legal to just move it from one fund to another at NAV can you do that? It is it is currently those rules are likely changing in the short term but there is a process that we can go through that allows us to cross trade between funds you know there's a approved process with our risk team to make sure that everyone's being treated fairly but as of right now that that is doable going forward like I said that the rules will be changing around that. Is that because of SEC or because of Vanguard? An SEC rule change yeah. Oh interesting so the bond would actually have to go out of one fund to someplace else and then come back into the other fund? Yeah the two funds would not be able to cross directly with one another and you know which you're given kind of the nature of the bond market it's not a guarantee that that particular bond would make its way back to you know the other fund there's a lot of friction in the in the fixed income markets relative to an exchange traded market where you know certain bonds are going to be available certain days and then they may not trade other days so you can never be sure that you're going to be able to get the bond that you want when you want it. You have a short term bond index bond, intermediate term bond index fund and there's so there's different pieces of say the aggregate bond market that are broken up into different maturities different credit ratings and right now if a bond let's say that was in the intermediate term corporate bond fund got to a certain maturity where it would normally be sold and the short term corporate bond fund index fund needs it you could move it in but what you're saying going forward you may not be able to do that. That's right at least not and at least not directly in between the two again an SEC rule would prohibit that going forward. Is that rule already in place or are you just anticipating it's going to happen? It'll be in place I believe in September of this year. Do you think this will add costs to managing these portfolios? We've kind of gone through a lot of different scenario analysis of how we can handle this and at the end of the day it's pretty de minimis in some ways it adds opportunity for us to be a little bit more strategic about how we move bonds from one one fund to another throughout the month we may have opportunities where because of new issues we might be overweight credit and that might be a decent time to sell out of those those bonds that you described that might be falling out of that benchmark and things of that so we've kind of gone through a lot of different iterations and feel like we're in a pretty good place to have a small if any impact to the funds. So the total bond market itself the index that you're tracking is the Bloomberg U.S. aggregate float adjusted index and that index has 12,500 bonds in it and according to the latest information on the Vanguard website the total bond market fund has about 10,150 so there's a discrepancy there of maybe 2,300 bonds and so why would there be such a large discrepancy whereas if this was a stock index fund it would generally be almost every stock that trades out there so why is it not that way with bonds? Yeah that's a good question Rick and the example I think that kind of clarifies it a bit is you've got a stock index funds that have securities that trade on exchange so something like an S&P 500 it's quite easy to go out and buy those 500 stocks in the right proportions and get tracking that benchmark. What you don't have in the bond market is that same exchange traded mechanism so everything in the bond market trades over the counter which really means that as a trader or PM you need to go out and find the bonds that you that you need to trade and you also have a dynamic that the fixed income market is really a buy and hold market. Plastic carries that don't trade that get purchased at new issue and get the term is put away they get put into someone's portfolio and you really don't don't see them come out so what sort of happens then is because of those dynamics myself my team we need to go out and build samples of the markets to replicate the major risk factors to ensure that we're going to get tight tracking but we need to do in a way that that understands that there are limitations of what we can and can't buy and we have to be by definition overweight some things and underweight other things. The team here will break the market into sort of subcomponents and we have experts that will be responsible for building the sample within that subcomponent with a bent tour trying to add a little bit of value at the margin. Tracking is always job one for us but understanding that we have to be overweight some places and underweight others. We try to do that pretty deliberately leverage our credit resources credit research team as well as our traders expertise to continually buy bonds that are a little bit cheaper sell the bonds are a little bit richer and over time you have that accrued to the funds. And then your analysis how much hub that has actually accrued to the funds you have like basis points or something that you could point to and say yes we actually added this much value by doing that type of trading. Yeah it's not a typical year we're not talking about huge numbers here in terms of basis points. One to two basis points would be pretty typical year and first of all we're generally able to overcome our transactions cost and then eat into the expense ratio by maybe a basis point or two basis points. So not huge in terms of basis points but when you convert that into dollars and cents you know you're talking about some pretty big numbers. So the the total bond market has a ETF attached to it as a share class but that trades differently than cash coming into the total bond market fund itself. And the ETF share class according to the data on your website is about 83 billion or so of that 300 billion in the total bond market. What I'm really curious about is does it enhance the fund in some way in other words the performance or does it lower the cost because you have this ETF share class. Yeah like you mentioned it's really just a it's a separate share class of of the total bond one fund. So a lot of ways we're indifferent about how cash comes to us. If it comes through the mutual fund it's more traditional and cash if it comes to us through the ETF channel it's going to be more in kind bonds. Having the ETF attached it has a couple nice benefits for us. It allows us to add additional diversification through the ETF channel as we negotiate custom baskets with market makers and we're taking those in every day and we're able to take those in on the bid side of the market so in a way we're able to grow the asset base you know without explicit transactions costs attached to it. There's also some tax deferral benefits through the in kind process and when we do have redemptions we're able to send out some of the lower cost lots that we might otherwise have to to trade at a gain. So those couple things are additive to the mutual fund shareholders from the ETF. Let me circle back to just the observation about the titling of the total bond market index fund and the reason I circle back to this is because when I interviewed Nick from Thunberg they call it an aggregate bond a U.S. aggregate bond market index but Vanguard calls the fund a total bond market index. So could you you know explain why doesn't I guess my question be why doesn't Vanguard call it the U.S. aggregate bond market index why is it the total bond market? Yeah it's really the broadest fund that we offer at least that's purely U.S. focused it's really probably the investment grade component of it that we would say is the total investment grade market. You know some of the components that people might argue should be included we would be things like high yield and EM but then you're sort of straying outside of this investment grade mandate and you know frankly I think people have certain expectations of bonds that probably align a lot more with investment grade performance versus being in something that's high yield or emerging markets that you know at times are going to trade a lot more with a higher high beta to equities at times so it's really the investment grade piece that we're wrapping that total label around. I think it was 2010 Vanguard decided that they wanted to change the index that they were tracking slightly to a float adjusted index and this is different than your competitors like I should. Why Vanguard made that change and made that decision to go that direction? Sure in terms of the float adjustment the standard U.S. aggregate has always adjusted for Fed holdings of treasuries so if you compare the the ag versus float adjusted ag that component is the same where there was a deviation was when the Fed started to buy mortgage securities you know post GFC and start to take those onto their balance sheet you know the decision was made that the sort of top level ag was not going to adjust for those. We felt pretty strongly that it would be best practice to adjust for float that's being taken out of the market really the biggest difference as you see between the two is the the weight in mortgages is quite a bit lower in the float adjusted but that then redistributes the entire pie so you'll get you know a bit higher in credit exposure you'll get a bit higher in in treasury exposure. We felt it was best practice we don't want to be trying to buy in markets where we know that the Fed is out there and in somewhat of an uneconomic way taking supply out of the market but it's not perfect right you could argue like I said it's a buy and hold market there's a lot of bonds that are on balance sheets of foreign banks on insurance companies or pensions that are probably never going to trade but the data to really do something like that just just really isn't that reliable and available so you know we felt it was a good step we felt it was a the right step for our investors you know looking at it over five-year look back float adjusted as you know outperform slightly hasn't really been dramatic but a slight outperformance over a for a five-year period but what you will see too is you know as the Fed is going to unwind QE and and let mortgages roll off and let treasuries roll off and you know potentially if they get more active actually sell what you will see is that float come back into the market and you'll see a convergence then between the float adjusted ag and sort of the the standard ag. Let's talk about return for a minute because it has been a difficult market here for investors I think that Nick was telling us that you had to go all the way back to I think the 1970s to find a period of time when in one quarter the aggregate bond market lost as much as it did in the first quarter of 2020 so I want to talk about the different elements of return coupon yield roll yield capital appreciate all the things that go into the return yeah sure really when you're investing in bonds you're generally investing to earn that yield and that yield it's really a combination of coupon as well as the dollar price of the bonds in the portfolio at the time and sort of taking together that will give you a yield and that should be a that should be a pretty good estimation of what you should expect to earn over at least the short term we've obviously come from a period of really low rates a lot of times we'll think about things in terms of like break-even you know spread spread moves or break-even interest rate moves and when you're at such a low level of yield a very low hurdle rate in terms of of the yield that you're looking to earn or expecting to earn it doesn't take much in terms of a backup in rates before you overwhelm that yield and you you actually go negative in total return and that's what we've seen obviously over the past couple of quarters as Lation has kicked up and you know the Fed has been very local about their plans you know the golden rule that you always have to keep in mind is that rising rates aren't always a bad thing it really has to do with your investment horizon and the product that you're in so rule of thumb would say that if you have an investment horizon that's longer than the duration of your fund you should actually welcome higher rates because what's going to happen is you're going to have an opportunity you know as you also hire you're going to continue to reinvest and that will continue to sort of accrue and compound you know through the life of that investment so like anything it's always important to make sure you've got the right product it's within your risk tolerance or risk budget and you're able to to write it out because you are in the right product. I want to talk about the concept of roll yield where you've got a yield curve now that's very steep and the total bond market aggregate U.S. aggregate index once a bond gets to one year it comes out of the index because now it's a cash element it's a cash security if you're buying these at five years or six years and you hold it until one year but you don't hold it to maturity there's an excess return that you could pick up if you have this normal yield curve can you discuss that and how that's affecting how that has affected the return of this fund over the years. Just kind of going back to this idea that we're building samples we make a lot of active decisions on a daily basis within kind of the construct of bond indexing again with with tracking as a number one goal but if something like you described we're not mandated to sell something that goes under a year and if it's really attractive we'd be happy to hold that and it may that's a trade-off somewhere else in the fund within our risk budget but we always have the lens of does that make sense can we hold onto a bond that has we think has a lot of value and not take a bunch of risks elsewhere you certainly can't do that all the bonds that are going to fall under a year else you would end up taking a curve that somewhere along the yield curve in the fund but there is a lot of discretion for us to do that in one of those opportunities arise. We have a question that came up with Nick and it had to do with pricing bonds because we already discussed the fact these bonds that you have in your fund are put away that don't trade but they need to be priced every day and Nick was telling us about the services that they use to price their bonds and does Vanguard use the same services or is it different and if it's different how does it affect the NAV of the index versus the portfolio? In most cases we don't use the same service there are some pockets where we do for us as an index fund provider that would probably be the lowest tracking option for us would be to use whatever value that our index providers come up with. We found over the years that we want to take a little bit more of a broader look and use a variety of different pricing services so we bring in two or three or more prices every day for different markets our pricing team within our fund accounting group will will do the due diligence to really quality check all the different pricing sources and use the ones that we really think are most accurate for that particular sector in that particular fund. Let me ask another question maybe a little bit tougher when the bond market has a bad day and credit spreads just widen very rapidly and the liquidity just dries up ETF prices plummet and sometimes ETFs close at much lower prices than their fund their index fund equivalent. I think we might have seen this back in 2020 might have seen it back in 2007 2008 where we've seen this big gap between market price of the ETF at close and the actual NAV of the open-den fund and I think that you know a lot of people try to explain it a lot of people are saying that this is actually fair but number one could you explain what happens and your view of all that. Sure yeah so I think the example that you probably you know or at least as most fresh in mind is it's March 2020 when you saw for a small period of time bond ETFs closing at relatively large discounts to to NAV. I think the first thing I would say is that was a really unprecedented period of volatility for for the fixed income ETFs and it was a pretty big test for how resilient they would be. I guess I'll go back to first of all you know the diligence that we put into our NAV you know makes us feel really good about you know where we're coming in every night with NAV pricing so the deviation on the ETF side has a lot to do with sort of the price of liquidity at that time in the marketplace and the demand for sort of instant liquidity taking place when you have a market that's somewhat frozen up and then you think about okay well you know there should be this arbitrage mechanism that brings things back in place but then you get you got to kind of think about the state of the market where it was and the arbitrage trades that would need to happen to close up that that gap and that would sort of involve you know someone going out buying shares in the market redeeming them to to the fund and getting bonds in return and in an environment like that you know from hour to hour for minutes a minute you don't really know what those bonds could be worth they could gap lower by two points by the time you get around to actually liquidating and trying to you know affect that arbitrage so you know there's just so much uncertainty and friction that that arbitrage mechanism definitely gets weakened a bit in those times so but big picture you know there were some small blips but for the most part we were very encouraged of how the fixed income market you know behaved and how resilient it was and how big of a part it was in terms of kind of ultimate price discovery over the course of a few months as the market tried to right itself and and work out some of the volatility and the dislocation that we had seen so most people who are buying whole investors or should just kind of ignore these daily fluctuations unless perhaps you wanted to do some rebalancing in which case if you wanted to do some rebalancing and that day in March where things went crazy and a gap between the trading price of the ETF and the NAV of the open-ended fund was so wide that it would have been better off selling the open-ended fund if you had those shares rather than the ETF right that the open-ended fund would have probably been a better option at that time but you know there's reasons that people hold the ETF and you know some of it is this you know instant liquidity you know getting out you know midday you know we also have some frequent trading policies that would restrict folks from coming into and out of the total bond mutual funds which wouldn't occur in the ETF so there's there's a lot more flexibility there as well so there's a little bit of trade-offs on both sides are you finding it more difficult trading bonds with the current environment than talking about higher interest rates and so but this is a great some illiquidity in the market is it more difficult for your desks I wouldn't say it's it's anything that's unexpected or out of the ordinary in a period of volatility like this I think anytime you go through this there's a bit of a price discovery process takes the market a while to settle in sort of back to to more normal levels so there's a bit of it for sure but yeah I would say it's well within what we would expect. You're an important person you're managing them a lot of money for a lot of people is there anything you wanted to add to this conversation? I mean I could just maybe offer a couple thoughts we're obviously talking about total bonds today but you know Vanguard has a really full lineup of both active and index products in the bond market that really offer investors with a lot of options and a lot of flexibility to to tailor that bond exposure and we do believe in total bond as a core but you know core doesn't mean 100% if somebody is of the mind that they want more more corporate exposure or they want a shorter duration or a longer duration you know we have a lot of great options to supplement that exposure and make sure people get the risk that they're comfortable with and the risk that kind of fits their their long term asset allocation so again total bond we think is a great core but you know there's a lot of other sort of building blocks we would call them to to add on to build a bond portfolio that gets you really close to your objectives. Josh thank you so much for your time today really appreciate the insight and really appreciate what everything that you and your team do for us all at Vanguard. Oh thanks Rick it's been it's been great. This concludes this edition of Bogelheads on investing. Join us each month as we interview a new guest. In the meantime visit bogelcenter.net bogelheads.org the bogelheads wiki bogelheads twitter listen live each week to bogelheads live on twitter spaces the bogelheads youtube channel bogelheads facebook bogelheads reddit join one of your local bogelheads chapters and get others to join thanks for listening