Vanguard’s Cheapest Investment-Grade Bond ETF Costs Less Than $3 a Year on $10,000. Hardly Anyone Mentions It.

Vanguard’s most popular bond ETF is also the largest U.S.-listed bond ETF by assets under management (AUM). It is the Vanguard Total Bond Market ETF (NASDAQ:BND). For a 0.03% expense ratio, investors get exposure to more than 10,000 investment-grade corporate bonds, Treasury bonds, and mortgage-backed securities spanning short-, intermediate-, and long-term maturities. It is highly popular because it is cheap, diversified, and simple. A lot of investors use it as the bond allocation for the classic 60/40 balanced portfolio.

But like many jack-of-all-trades funds, BND is also a master of none. It is not the highest-yielding bond ETF. It is not the safest bond ETF. And it is not the most targeted way to position yourself based on interest rate expectations or credit quality preferences. It really sits right in the middle of the pack. That is not necessarily a bad thing. For investors who just want broad exposure to the U.S. investment-grade bond market, BND remains a perfectly reasonable option.

Still, if you want to be a bit more discerning with your bond allocation, Vanguard has several alternatives that are just as affordable while offering much more specificity. If your focus is investment-grade corporate bonds, meaning bonds rated BBB and higher, one ETF worth considering is the Vanguard Intermediate-Term Corporate Bond ETF (NASDAQ: VCIT).

What Is VCIT?

VCIT is a passive ETF that tracks the Bloomberg U.S. 5–10 Year Corporate Bond Index. This benchmark currently includes 2,235 investment-grade corporate bonds. The portfolio is dominated by BBB-rated bonds, which make up roughly 47% of holdings, followed by A-rated bonds at approximately 45%. While there are some AA- and AAA-rated issuers in the fund, they represent a much smaller share of the portfolio. That is fairly typical for corporate bond markets because there simply are not many companies with extremely high credit ratings.

In terms of interest rate sensitivity, VCIT falls squarely into the intermediate-duration category with an average duration of 6.1 years. That means years of rising rates, such as 2022, can hurt the ETF’s net asset value. On the other hand, periods of falling rates, like what occurred during the COVID-19 crisis, can provide a meaningful tailwind.

One thing I like about Vanguard’s lineup is that investors can also choose shorter- or longer-duration versions of this same strategy while maintaining similar credit quality and similarly low fees. And fees are really where VCIT shines. At a 0.03% expense ratio, a $10,000 investment in VCIT costs just $3 a year in fee drag. That matters because lower fees allow investors to keep more of the income generated by the portfolio for themselves. Right now, VCIT is generating a fairly attractive 5.13% 30-day SEC yield.

The Fine Print for Taxes

If VCIT has one major drawback, it is tax inefficiency. According to Vanguard, over the trailing one-year period, VCIT delivered a respectable 6.08% total return before taxes. However, after accounting for taxes paid on the ETF’s monthly distributions, Vanguard estimates that return would have fallen to just 4.07%.

That is roughly a 2 percentage point reduction in return from taxes alone, and that is exactly why tax drag matters just as much as headline yield. Unfortunately, there is no easy workaround here. VCIT holds taxable corporate bonds, meaning the distributions are generally taxed as ordinary income at both the federal and state levels.

Personally, I think the best place for a investment-grade corporate ETF like VCIT is inside a tax-sheltered account such as a Roth IRA, where investors can maximize the benefit of the higher yield without giving such a large portion away to taxes.