The Best Vanguard Funds for Income

With interest rates remaining stubbornly low, keeping fees on your income investments down is more important than ever. So word that Vanguard Group, the industry’s cost leader, is expanding its lineup of low-fee income funds is welcome news.

In January, the firm announced plans for its first municipal bond index fund. To be more precise, Vanguard introduced two versions of the same product: Tax-Exempt Bond Index, a mutual fund version, and Tax-Exempt Bond ETF, an exchange-traded fund. The funds will track Standard & Poor’s National AMT-Free Municipal Bond index, which owns a broad mix of high-quality tax-free muni bonds. Like all Vanguard funds, the mutual fund will not levy a sales charge. The expected expense ratio for the mutual fund is 0.20%; for the ETF, it’s 0.12%. The average expense ratio for national municipal bond mutual funds is 0.84%, according to Morningstar. (The funds’ symbols are not yet available.)

Muni bonds appeal to high earners because the interest they generate is generally exempt from federal income taxes, and sometimes from state and local income taxes as well. The S&P National AMT-Free Municipal Bond index yields 1.7%, which is the equivalent of a taxable yield of 2.5% for someone in the 33% federal tax bracket. By comparison, the yield on the benchmark 10-year Treasury bond, whose interest payments get dinged by Uncle Sam, is just 2.1%. (All yields and returns are as of February 19.)

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If you’re in a low tax bracket or invest through a tax-advantaged retirement account, the tax exemption becomes less important. But you can choose from plenty of other low-cost Vanguard income funds.

For a core bond fund, you can’t beat Vanguard Total Bond Market ETF (BND). With more than 7,000 bonds in the portfolio, the ETF hews to an index of investment-grade U.S. corporate and government debt. It yields 2.0% and charges just 0.08% in annual fees. That’s lower than the index mutual fund version of the fund, which costs 0.20%. Incidentally, the ETF qualifies for commission-free trades at Vanguard and TD Ameritrade.

Because bond prices move opposite to yields, it’s a good idea to keep at least some of your fixed-income holdings in bonds with short maturities today. That way, if rates rise—the Federal Reserve is expected to begin increasing short-term interest rates later this year—you can minimize principal loss and reinvest more quickly at higher yields.

One good option is Vanguard Short-Term Investment-Grade (VFSTX). A member of the Kiplinger 25, the list of our favorite no-load mutual funds, Short-Term Investment-Grade yields 1.6%. It owns high-quality bonds with an average duration of less than three years (duration is a measure of interest rate sensitivity). As such, if interest rates were to rise by one percentage point, the fund’s net-asset value per share would probably fall about 3%. Annual fees are 0.20%.

If you want even more protection against bond prices falling, consider Vanguard Ultra-Short-Term Bond (VUBFX). Launched in February, the mutual fund will keep its average duration to about one year. As such, it will be less interest-rate-sensitive than Short-Term Investment-Grade. It also will pay less, though whatever amount it does disburse may make it an attractive alternative to money market funds, which pay zilch nowadays (Vanguard hasn’t disclosed the fund’s yield yet).

“If you can tolerate some change in bond prices, you’re better off in Ultra-Short-Term than in a money market fund,” says Jeffrey DeMaso, director of research at Adviser Investments, a money-management firm that often uses Vanguard funds. The fund’s expense ratio is 0.20%.

For a bigger payout, consider Vanguard High-Yield Corporate (VWEHX). The fund invests in “junk” bonds, which are issued by companies with subpar credit ratings. High-yield bonds deliver relatively big interest payments, which makes their prices less sensitive to rate swings than prices of low-yielding high-quality bonds.Because energy companies are big issuers of high-yield debt, junk bond prices fell in the second half of 2014 along with the price of oil. But High-Yield Corporate’s conservative approach helped minimize the damage during the sell-off. Run by Wellington Management Company, the fund has 52% of its assets in the highest rung of junk bonds (those rated double-B), compared with 34% for the average high-yield bond fund.

The tilt toward higher quality means the Vanguard fund pays noticeably less than its benchmark—it yields 4.8%, compared with 6.2% for the Bank of America Merrill Lynch U.S. High Yield index, a broad measure of the junk bond market—but it also helps during periods of junk bond weakness. In 2014, the average junk bond mutual fund returned 1.1%, while High Yield Corporate delivered 4.6%. “It showed the strength of the fund’s approach,” says DeMaso. Fees are a below-average 0.23%.

You can also look for income on the stock side of your portfolio. One good option is Vanguard Dividend Growth (VDIGX), another member of the Kip 25. Wellington Management’s Donald Kilbride, who has been at the fund’s helm since 2006, aims to put together a portfolio of 50 or so stocks that, on average, will raise their dividends 10% annually over five years. Dividend Growth yields 2.1%, on par with the 2% yield of Standard & Poor’s 500-stock index.

Because Dividend Growth invests in stocks, it will be much riskier, at least over the short term, than just about any bond fund. But because it holds companies that regularly raise their dividends, it could well weather rising rates better than the typical bond fund. The fund’s long-term results have been superb. Over the past 10 years, Dividend Growth returned an annualized 9.3%, compared with 8.0% annually for the S&P 500. Annual expenses are 0.31%, about as low as you’ll find for an actively managed stock fund.