BND vs. AGG: Comparing Bond ETFs

Bond exchange-traded funds (ETFs) are a useful device for modern fixed-income investors. These ETFs combine the relative stability and portfolio diversification of bond mutual funds with the intra-day liquidity of stocks. The best bond ETFs top it off with a low cost.

In terms of assets managed, the two kings of the bond ETF space are the iShares Core U.S. Aggregate Bond ETF (NYSEARCA: AGG) and the Vanguard Total Bond Market ETF (NYSEARCA: BND). The two funds held greater than $60 billion in total assets under management (AUM), as of March 2016. This level of AUM is greater than other bond ETFs and far outpaces the rest of the investment-grade broad market category.

The iShares Core U.S. Aggregate Bond ETF is a product of BlackRock Inc. (NYSE: BLK) and part of its successful iShares ETF series. It is the older of the two funds by three and one-half years, having launched in September 2003. Backed by all the resources of the world's largest money manager, this ETF doesn't lack for recognition or marketing. Portfolio managers James Mauro and Scott Radell are in charge of the ETF's day-to-day operations.

The Total Bond Market ETF is Vanguard's preeminent domestic bond offering. In many ways, the Vanguard fund is a younger brother to the iShares fund. The two ETFs track the same index, albeit with slight variations in execution, and provide a healthy competition for low fees, safety and strong returns.

Both funds are passively managed ETFs. Passive investment strategies are designed to reduce total fund costs, making them less expensive investments. Before the BlackRock buyout, the iShares Core U.S. Aggregate Bond ETF was a much more expensive and sluggish fund, but competition has driven costs down sharply for both asset managers.

Both ETFs track the Barclays U.S. Aggregate Bond Index, the leading yardstick for domestic bond performance, though the Vanguard ETF follows a float-adjusted version of the index. The Barclays Aggregate Bond Index is a market value-weighted collection of the whole U.S. bond market, excluding municipal bonds, Treasury inflation-protected securities (TIPS) and high-yield bonds.

AUM for the iShares Core U.S. Aggregate Bond ETF totals greater than $34 billion, making it larger than the Vanguard Total Bond Market ETF by approximately $5 billion. The portfolio for the iShares ETF has a slightly longer average duration, at 5.53 relative to 5.42 years, and a higher average credit quality, at A+ relative to A. Each is very similar in terms of weighted average maturity and yield to maturity (YTM).

The two funds show extremely consistent financial figures. As of March 2016, the iShares Core U.S. Aggregate Bond ETF had an expense ratio of 0.08% compared to 0.07% for the Vanguard Total Bond Market ETF. They are the two most liquid bond ETFs, moving hundreds of millions of dollars per day in daily trades. Bid/ask spreads are comparatively tiny for each, often less than 1.2 cents for the iShares fund and 1.5 cents for the Vanguard fund.

As bond-backed funds, the iShares Core U.S. Aggregate Bond ETF and the Vanguard Total Bond Market ETF are indirectly exposed to counterparty risks in their underlying portfolios. The iShares ETF carries slightly less counterparty risk at first glance, owing to its better credit quality. Even though passive funds seem to operate on autopilot, each is also exposed to some management risks.

Perhaps a larger concern is inflation risk. Treasury-heavy bond ETFs rarely generate top market returns. Expect shareholders to struggle to offset an increase of 3 or 4% in the real cost of living over one year. Interest rate risk is also a problem since the intermediate-term nature of these ETFs makes them more susceptible than shorter-term instruments.

The trailing five-year performances for the iShares Core U.S. Aggregate Bond ETF and the Vanguard Total Bond Market ETF are virtually identical. Between March 2012 and March 2016, each fund returned an average annualized 3.52%. The iShares ETF has tended to be the more expensive fund over that period, so the Vanguard ETF probably demonstrated stronger true performance by a very small margin. During the 12 months between March 2015 and March 2016, the Vanguard ETF returned 1.47% to the iShares ETF's 1.39%.

Expert opinion is almost universally positive for both funds, though rarely overwhelming. Morningstar awards three stars to each of these ETFs. U.S. News Money prefers the iShares fund, giving it the best intermediate-term bond spot, while the Vanguard fund was ranked at number eight.

Because the strategies, portfolios, benchmarks, performances and costs of the iShares Core U.S. Aggregate Bond ETF and the Vanguard Total Bond Market ETF are so similar, there isn't an investor group more suited for one or the other. Generally speaking, either fund can fit as a core holding for retirement-conscious investors or as a satellite for those who want high-grade domestic bond exposure. Low yields and small returns make them ill-suited for younger or more aggressive traders.