SO FAR, MY APPLICATION of common sense has been applied largely to the stock market, to equity mutual funds, and to equity index funds. But the relentless rules of humble arithmetic with which I’ve regaled you also apply—arguably even more forcefully—to bond funds.

Perhaps it’s obvious why this is so. While a seemingly infinite number of factors influence the stock market and each individual stock that is traded there, a single factor dominates the returns earned by investors in the bond market: the prevailing level of interest rates.

Managers of fixed-income funds can’t do much, if anything, to influence rates. If they don’t like the rates established in the marketplace, neither calling the Treasury Department or the Federal Reserve, nor otherwise trying to change the supply/demand equation, is likely to bear fruit.

Why would an intelligent investor hold bonds?

Over the long term, history tells us that stocks have generally provided higher returns than bonds. That relationship is expected to continue during the coming decade, although rational expectations suggest that future returns both on stocks and on bonds are almost certain to fall well short of historical norms.

As noted in Chapter 9, I estimate that annual returns on bonds over the coming decade will average 3.1 percent. To summarize, since 1900, annual returns on bonds have averaged 5.3 percent; since 1974, 8.0 percent; in the coming decade, likely 3.1 percent, plus or minus.

So today, why would an intelligent investor hold any bonds at all? First, because the long run is a series of short runs, and during many short periods, bonds have provided higher returns than stocks. In the 117 years since 1900, bonds have outpaced stocks in 42 years; in the 112 five-year periods, bonds have outpaced stocks 29 times; and even in the 103 fifteen-year periods, bonds have outpaced stocks 13 times.

Second, and perhaps more important, reducing the volatility of your portfolio can give you downside protection during large market declines, an anchor to windward, so to speak. The conservative nature of a balanced stock/bond portfolio can reduce the possibility of counterproductive investor behavior (i.e., getting frightened when the stock market plunges and liquidating your stock position).

Third, while bond yields are near their lowest levels since the early 1960s, the current yield on bonds (3.1 percent) still exceeds the dividend yield on stocks (2 percent).

A similar gap between bond yields and stock yields.

In fact, that positive yield spread of 1.1 percentage points for bonds over stocks is remarkably close to the 1.4 percentage point yield advantage held by bonds during the recent era (since 1974, 6.9 percent average yield on bonds, 5.5 percent average yield on stocks). So even in this era of low interest rates (and low dividend yields), bonds remain relatively competitive.

Given these considerations, the question then becomes, not “Why should I own bonds?,” but “What portion of my portfolio should be allocated to bonds?” We’ll tackle that question in Chapter 18.

Bond fund managers track the bond market.

As a group, managers of bond funds will almost inevitably deliver a gross return that parallels the baseline constituted by the current interest rate environment. Yes, a few managers might do better—even do better for a long while—by being extra smart, or extra lucky, or by taking extra risk.

Alas, bad decisions often come home to roost, and can impair longer-term returns. (Reversion to the mean often strikes.) What’s more, even if bond managers add a few fractions of 1 percent to the funds’ gross returns, they rarely overcome the fund expenses, fees, and sales loads involved in acquiring their services.

Bonds vary in riskiness.

While these costs make the task of improving returns far more difficult, overly confident bond fund managers may be tempted to take just a little extra risk by extending maturities of the bonds in the portfolio. (Long-dated bonds—with, say, 30-year maturities—are much more volatile than short-term bonds—say, two years—but usually provide higher yields.)

Managers also may be tempted to increase returns by reducing the investment quality of the portfolio, holding less in U.S. Treasury bonds (rated AA+) or in investment-grade corporate bonds (rated BBB or better), and holding more in below-investment-grade bonds (BB or lower), or even some so-called junk bonds, rated below CC or even unrated. Heavy reliance on junk bonds to increase the income generated by your portfolio subjects your bond investment to high risks. (Of course!) Investors who seek to increase the yield on their bond portfolios by investing in junk bond funds should limit themselves to small allocations. Caution is advised!

Three basic types of bond funds.

One beneficial feature of bond mutual funds is that they often offer investors three (or more) options that deal with the trade-off between return and risk. Short-term portfolios are designed for investors who are willing to sacrifice yield to reduce volatility risk. Long-term portfolios serve investors who want to maximize yield and are prepared to deal with higher volatility. And intermediate-term portfolios seek a balance between income opportunity and market volatility. These options help make bond funds attractive to investors with a variety of strategies.

Like stock funds, actively managed bond funds lag their benchmarks. Why? The arithmetic of costs.

When all is said and done, bond funds of comparable maturity and credit quality are likely to capture the gross returns of the bond market segments dictated by their policies. And after their expense ratios, operating costs, and sales loads (if any) are deducted, their net returns will fall short. Where bonds are concerned, Brandeis’s warning becomes particularly meaningful: “Remember, O Stranger, arithmetic is the first of the sciences and the mother of safety.”

There are too many types of bond funds to try your patience by examining the performance of all of them. So I’ll now focus on funds in the three major maturity segments (short-, intermediate-, and long-term bonds), and two major quality segments (U.S. government and investment-grade corporate bonds).

In Chapter 3, I noted that the returns of 90 percent of actively managed equity mutual funds lagged their benchmark indexes, as reported by S&P in its SPIVA (Standard and Poor’s Indices versus Active) report.

The SPIVA report also compares the returns of bond mutual funds in various categories to their appropriate benchmark indexes. During the 15-year period from 2001 to 2016, the performance of the bond indexes is also impressive, outpacing an average of 85 percent of all actively managed bond funds in the six categories—short-term, intermediate-term, and long-term bond funds grouped by both U.S. government and investment grade corporate sectors (Exhibit 14.1). The appropriate indexes also outperformed the managers of municipal bond funds (84 percent) and high-yield bond funds (96 percent).

The important role of costs in shaping bond fund returns.

The average shortfall in the returns of intermediate-term and short-term Treasury and corporate bond funds relative to index funds during the past 15 years is estimated by SPIVA to be about 0.55 percent per year. The average bond index fund carried annual costs of about 0.10 percent, while the expense ratio for actively managed bond funds averaged 0.75 percent. The average difference in expense ratios came to about 0.65 percent, slightly larger than the performance gap. Once again, it is clear that low costs account for a dominant portion of the index advantage.

The total bond market index fund.

The first total bond market index fund—formed in 1986, and still the largest—tracks the Bloomberg Barclays U.S. Aggregate Bond Index. Nearly all of the major all-bond-market index funds have followed the leader. These index funds are extremely high in quality (63 percent U.S. government-backed bonds, another 5 percent in AAA-rated corporates, 32 percent rated AA through BAA, and no bonds rated below investment grade). During the past 10 years, that total bond market index fund earned an annual return of 4.41 percent, just 0.05 percentage points behind the 4.46 percent annual return of its target index, a remarkable parallel.

Since high-quality portfolios almost always produce lower yields than lower-quality portfolios, the total bond market index fund’s yield in mid-2017 is a relatively low 2.5 percent when compared to the 3.1 percent yield of the bond market proxy that we used earlier in this chapter. The difference: the bond portfolio that we constructed for this analysis underweights U.S. government issues (50 percent) and overweights investment-grade corporate bonds (50 percent) relative to the index, thus producing its higher yield.

In order to achieve such a 50/50 government/corporate bond portfolio, investors who require a higher yield than the total bond market index fund (yet still seek a high-quality portfolio) might consider a portfolio consisting of 75 percent in the total bond market index fund and 25 percent in an investment-grade corporate bond index fund.

The value of bond index funds is created by the same forces that create value for stock index funds.

The reality is that the value of bond index funds is derived from the same forces that create value in stock index funds: broad diversification, rock-bottom costs, disciplined portfolio activity, tax efficiency, and focus on shareholders who place their trust in long-term strategies. It is these commonsense characteristics that enable index funds to guarantee that you will earn your fair share of the returns in the stock and bond markets, even as they do in all financial markets.

Indeed, many of the earlier chapters in this book that were focused on stock funds could just as easily be the titles of a series of bond fund chapters—especially, “Focus on the Lowest-Cost Funds,” “Selecting Long-Term Winners,” and “Profit from the Majesty of Simplicity and Parsimony.” These rules are universal.