Vanguard Moves Bond Funds to Float Indexes

Vanguard is migrating a dozen of its bond index mutual funds to benchmarks that better reflect market liquidity. Observers say the move represents the government’s unprecedented intervention in the bond markets, and will likely lead other fund companies to follow suit.

The fund company will adopt the Barclays Capital float-adjusted indexes, a type of benchmark that is more commonly associated with stocks. The move will take effect in the fourth quarter of 2009.

The previous benchmark included $1 trillion in mortgage-backed securities and $125 billion in agency bonds that have been purchased by the government to keep mortgage rates low and sustain the ailing housing market. These securities are no longer on the market and therefore no longer liquid. “That could make it hard for the fund to track its index without [incurring] additional transaction costs and tracking errors,” said Daniel Culloton, an associate director of fund analysis for Morningstar. Because trading mutual fund shares on a non float-adjusted index impedes the liquidity of those securities, it widens bid-ask spreads, the difference in asking price between securities buyers and sellers. Ultimately, that increases investing costs for consumers, according to Culloton.

Acknowledging this, Barclays Capital came out with new float-adjusted indexes at the end of July that exclude the securities held by the government, Culloton said. Vanguard has been worried that the federal government could end up owning a significant portion of the securities market, he said. “Lots of bond investors been paying close attention.”

It is unclear whether Vanguard is the first to migrate its funds to Barclays Capital’s new indexes. But if it is, that move would follow a similar course of action that Vanguard took involving equities. Earlier this decade, there was a big move to do this on the equity side, Culloton said, and Vanguard was an early adaptor. “Now it is standard practice that equity index funds track float-adjusted equity indexes, which only include shares of companies that trade freely on the market.”