4 Vanguard Bond ETF Picks For 2025

Bond market conditions look challenging, but these ETFs offer a combination of healthy yield, upside potential and managed risk.

The bond market is still struggling to recover from one of the worst bear markets in history in 2022, but there are signs of optimism. In particular, Treasury bills were a source of risk-free 5% yields throughout most of 2024. High yield bonds gained about 8% on the year as investors continue to shun any notion of credit risk in corporate bonds. Long-term Treasuries, however, remain the weak spot. They lost another 8% and still sit more than 40% below their all-time high.

That left Vanguard's bond ETF lineup in a tougher spot. The one area of fixed income that did well, high yielders, isn't represented in their lineup. Its best performers were mostly just T-bill and short-term bond ETFs. It failed to hit on some of the sector's biggest winners, save for the Vanguard Emerging Markets Government Bond ETF (VWOB).

Don't worry though. Vanguard is doing just fine. Its fixed income lineup as a whole still took in tens of billions of dollars in 2024, led by the Vanguard Total Bond Market ETF (BND) and, perhaps as a bit of a surprise, the Vanguard Total International Bond ETF (BNDX) and the Vanguard Intermediate-Term Treasury ETF (VGIT), despite middling performance.

But I still think there are opportunities for positive returns, even if they're not the sexiest ETFs in the world. Given the uncertainty ahead, 2025 may not be the year for home run swings, but instead solid, steady performers.

With that being said, let’s take a look through Vanguard's bond ETF lineup to identify four funds that could do particularly well over the next 12 months.

Vanguard Short-Term Inflation-Protected Securities ETF (VTIP)

source: ETF Action

Back in 2022, TIPS were the hottest fixed income product in the world. With inflation rates hitting 10% and higher in some areas of the world, the income-producing sleeves of most portfolios were gettg crushed and investors were looking for anything to ease the pain. The upward resetting of TIPS yields allowed investors to at least come much closer to keeping pace with inflation and reminded the markets why holding at least a little bit of this in your portfolio at all times isn't a bad idea.

VTIP takes a pretty straightforward approach by including all inflation-protected public obligations issued by the U.S. Treasury with remaining maturities of less than 5 years. As one bond matures, the next new issue is added and that keeps duration at roughly 2.5 years pretty consistently. VTIP has been one of the best-performing TIPS ETFs over the past year and with a Vanguard-ian expense ratio of just 0.04%, it's one of the cheapest as well.

Why This ETF Is A Top Pick

With inflation rates moving higher in the United States and other developed markets around the world, a fund designed to provide inflation protection makes a lot of sense. Plus, if inflation continues to pick up, that means interest rates are likely to keep moving higher as well. What happens when rates go up? Bond prices come down. In that scenario, most funds could be losing value, but one that's able to least adjust its yields to inflation and maintains a pretty modest duration should have a better than average chance of outperforming.

Curiously though, TIPS haven't been outperforming the bond market so far in this cycle. That's the opposite of what happened in 2022 when TIPS began leading ahead of the big spike in inflation. Perhaps that's yet to come or investors just don't think inflation is a big risk yet, but I still like the risk/reward tradeoff here.

Vanguard Short-Term Treasury ETF (VGSH)

source: ETF Action

After years of near-zero interest rates and an inability to generate anywhere near an acceptable yield on fixed income, investors finally got their reward. By the end of 2022, the yields on 3-month T-bills were north of 4% and have been there ever since, even approaching 5.5% at one point. After 100 basis points of rate cuts by the Fed over the past 12 months have pushed those yields back down to around 4.3% where they are today, T-bills still remain a worthwhile income generator with virtually no risk.

VGSH isn't quite a Treasury bill ETF (it targets Treasuries with 1-3 year maturities remaining), but its <2 year duration ensures that volatility is very low. That could, however, make the fund slower to respond to short-term interest rate changes given the somewhat longer time period to maturity. In a lower volatility environment where the Fed holds rates steadier, which is what 2025 is looking more and more like, that tends to matter less, making the potentially higher yield a lower risk source of extra return.

Why This ETF Is A Top Pick

This is a bet that 1) the Fed makes few, if any, rate cuts in 2025, thus keeping interest rates elevated and 2) the reason that they're elevated is because sticky inflation requires tighter policy restrictions, creating a headwind for lower quality and longer-term bonds. In other words, it's a bet that the stock and bond markets won't have nearly as easy a time generating gains as they have during the past two years and safe havens could find new interest.

I still ultra-short and short-term Treasuries as income options regardless. A risk-free 4-5% yield isn't something that should be ignored. A few years ago, income seekers were practically begging for any kind of reasonable yield on their investments. Now, they can capture a risk-free yield that's been enjoyed only two other times in the past quarter century. In 2025, they look like a good bet.

Vanguard Emerging Markets Government Bond ETF (VWOB)

source: ETF Action

It's snuck under the radar a bit, but emerging markets bonds were actually one of the best performing fixed income asset classes of 2024, right up there with U.S. high yield. All of this happened despite a stronger dollar, which acts as a headwind, but this fund is denominated in U.S. dollars, so it was able to avoid much of the currency volatility and potential downside. Several economies were showing signs of recovery, while central banks were taking steps to support those recoveries. VWOB is roughly half investment-grade debt and half junk bonds, so its exposure to the high yield space definitely helped performance and the comparative yield advantage helped fill in any performance gaps.

VWOB generally invests in bonds issued by emerging market sovereign governments with remaining maturities of at least one year. Only Saudi Arabian bonds account for more than a 10% country allocation, but this portfolio is spread out pretty well Asia, African and Latin American economies. A duration of around 7 years suggests that volatility can be elevated with this portfolio, but it's a pretty good representation of these regional bond markets overall.

Why This ETF Is A Top Pick

I kind of laid out the investment case for this ETF already. If the Fed is likely to hold policy rates fairly steady in 2025, but emerging central banks are likely to continue supporting economic recovery through lower rates, that could continue to swing things in this group's favor. Higher rates in the U.S. would generally contribute to a stronger dollar, negatively impacting foreign investment, but remember that VWOB is U.S. dollar-denominated, so it should be able to stay away from a lot of that risk.

There's always going to be elevated risk investing in emerging markets, but I think there's still more upside than downside in this group. With a lean towards more monetary support from global central banks likely in the coming year, the comparatively lower credit quality profile of VWOB could again work in its favor.

Vanguard Short-Term Tax Exempt Bond ETF (VTES)

source: ETF Action

Muni bonds have gotten more attention in recent years due to one factor - the U.S. federal debt. The government continues to spend at an historic pace, which has concurrently increased government debt at an equally historic pace. There's talk of more tax cuts on the way (because that's how politicians win elections) and that means the government's huge mountain of debt is only going to keep getting bigger.

At some point, the government is going to have consider raising taxes in order to stop this (or at least slow it down). With interest expense quickly becoming the largest line item in the federal budget and the Fed unlikely to be able to lower interest rates much for the foreseeable future, the squeeze is going to remain on. That could require a reset of what might work best in the fixed income space.

VTES invests in munis with maturities ranging from one month to 7 years (the current portfolio duration is 2.4 years). All of it is rated investment-grade and experiences very little turnover year-over-year. With an expense ratio of 0.07% and a current yield just short of 3%, it remains one of the better ETF options for investing in municipal bonds.

Why This ETF Is A Top Pick

If the government does ultimately decide to raise taxes to offset some of its spending, it's going to make federally tax-exempt muni bonds look more attractive. It's the same logic that financial advisors use for encouraging people to convert their retirement savings into Roth IRAs - pay the lower tax rate now instead of the likely higher tax rate later.

Admittedly, this narrative may take a little more time to actually play out as I'm sure the government will kick this can down the road as long as humanly possible. The current debt ceiling debate, however, is keeping this issue fairly close to the front page. If the debt ceiling issue starts to spook investors in even a small way, it could result in a wave of interest in munis.

Conclusion

As has been the case for a few years now, the fixed income market remains challenging. Long-term yields are on the rise worldwide and rising inflation rates could drag the entire bond market lower in the next year. Credit spreads are still historically narrow and that could amplify potential losses in the lower credit quality end of the market.

The ETFs listed above offer a combination of healthy yield, upside potential and managed risk. The fixed income market figures to be challenging in 2025, but these ETFs should help navigate conditions.