Criteria for selecting Bond ETFs

Question

My investments are split between 4 ETFs (US, International, REIT, and bonds). Until recently, bonds were a relatively small part of the portfolio so I didn't put much thought into it and selected a popular iShares bond ETF (AGG).

Now, bonds are the largest of the 4 ETFs, with about 40% of holdings. In addition, I need to hold bonds in taxable accounts because I've run out of room in tax-advantaged accounts.

The purpose of bonds is to reduce volatility, but now I have tax considerations, and as it becomes a larger part of my portfolio it seems I should at least consider yield.

What criteria should I consider in selecting one or possible more bond ETFs for this largest chunk of my portfolio?

For example, I could consider iShares LQD (corporate bonds) to increase yield or iShares MUB (muni) to avoid taxes. In addition, Fidelity is pushing an actively managed bond fund, claiming that active management is more successful with bonds than with stocks.

While there are plenty of guidelines for selecting stock ETFs it is hard to find good info for bond ETFs.

Answer 1

I handle bonds similar to how I do stocks, which is to say I assume the rest of the market knows more than me, so I pick the cheapest, most generic index funds available. Just like I don't overweight small caps or mid caps or large caps, I don't overweight Treasuries or municipal bonds or corporate bonds. So AGG is a great choice for me, as is BND at Vanguard. Although I use and like them, Fidelity has a vested interest in you believing that actively managed bond funds will be more successful than actively managed stock funds, so I wouldn't take their word for it.

The one exception to this would be if you're holding bonds in a taxable account, as you are. In that case I would calculate the tax-equivalent yield of AGG versus a tax-free municipal bond fund like MUB and see what makes sense.

Answer 2

I've been doing some research on this, and found a great answer on a Bogleheads forum:

I think the value of bond diversification is frequently over-estimated by simple (and flawed) analogy with stocks.

Bonds are most definitely not stocks. First off, in fixed income we have several assets that are for all intents and purposes 100% safe: Treasuries, bank products insured by FDIC and savings bonds. It would be entirely reasonable for someone to have 100% of their fixed income in a single Treasury fund, or entirely in CDs. Whereas holding one's entire stock portfolio in Apple or even Berkshire Hathaway would be a very bad idea.

Even the somewhat riskier bonds like investment-grade corporates or munis are an order of magnitude safer than their equity-like counterparts (e.g. the stock of the issuer or the real estate that backs muni revenues). A contract that says "pay this amount on this date or face bankruptcy court", together with an expiration date that frees you from the long term prospects of the issuer, makes for a fundamental difference in the nature of the asset.

The second difference comes from the role of bonds in the portfolio: their role / capability is to be stable, not to have high returns. If in your stock portfolio you omit e.g. solar and tech, you might find that the sectors you omitted go through the roof; making things worse, they could take away the bread and butter of the stocks you do own. Whereas the best thing that can possibly happen to solar bonds is that none of them default -- there's no exponential growth possible even if their issuers come to dominate energy production or whatever.

So don't overthink this. Get a safe enough fund and call it a day. Total Bond Market is good enough; so is Intermediate-Term Treasury and so are bank CDs. Get munis if your tax situation warrants it. But otherwise, time spent diversifying bonds is mostly wasted.