VCSH ETF: Close To A 5.5% Yield On The Horizon (NASDAQ:VCSH)

We wrote on Vanguard Short-Term Corporate Bond Index ETF (NASDAQ:VCSH) in another era. Risk-free interest rates were not visible to the naked eye forcing investors into investments with return-free risks, and the Federal Reserve was hibernating, qualitatively speaking. This was just in early 2021.

We pulled up the above rates as these are relevant to our fund’s portfolio, as we shall see later in this piece.

The last time we wrote on VCSH, while the advertised trailing 12-month distribution yield was 2.7%, the future was painting a sub 0.7% picture. With those kinds of numbers, investors were hanging their hat on a 2% return over three years, assuming the yields and spreads remained unchanged. We respect Vanguard and thunk (yes, thunk) that although it was the best in the business, there were better risk-adjusted opportunities out there. We included the following in the conclusion:

Vanguard can do better than anyone else in the market. Their extremely low expenses alongside their depth and breadth of the trading desks makes it very hard to be better than them, at least as far as passive indexing is concerned. So if they are getting you 0.69%, then no one else will do better. We don’t consider such yields as remotely useful to us and they all fall under the “return-free-risk” category.

Source: VCSH: Vanguard Flexes Its Muscles On Short-Term Bonds

The fund was performing as advertised until the rates started showing signs of life. Then it was curtains.

The negative 8% total return meant that you lost more than 11 times the annual yield you chased. Of course, as time went on, the maturing investments got replaced with better-yielding corporate bonds, providing a quantum of solace to its unitholders. When we last wrote on it, the distributions were decreasing month after month, while now they are doing the opposite. This provided a better offset to the price decline than what we expected back in January 2021.

With the improving fundamentals, but peak Fed rates on the horizon, let’s take another look at this fund.

Current Holdings

Designed to track the performance of the Bloomberg U.S. 1-5 Year Corporate Bond Index, 100% of VCSH’s portfolio is invested in USD-denominated investment grade bonds. 95% of the portfolio is made up of securities maturing in five years or less, with an average effective duration of 2.7 years. The holdings are primarily from the financial, industrial and utilities sector.

Being investment grade, there is a lower risk of default by the underlying issuers. Sure, some could get downgraded, but defaults are extremely rare in this timeframe. Also, the next time around, the fund would not reinvest in any company that got downgraded.

While holding investment-grade securities gives the ETF a higher protection from credit risk compared to a high-yield or junk bond fund, it also limits its earning potential as we can see below. We show the 30-day SEC yield for iShares 0-5 Year High Yield Corporate Bond ETF (SHYG) along with that of VCSH.

The 30-day SEC Yield represents income earned by the fund over the last 30 days, net of expenses. While this is not immediately reflected in the distributions paid by the fund to its investors, it is a harbinger of things to come. Similarly, the yield to maturity or YTM is a sign of where the 30-day SEC yield will be down the line. Keep in mind that this is a guidepost and ultimately the fund can choose the exact timeline of its distributions, within reason. The YTM of the VCSH portfolio was 5.3% about a month ago, which is where the SEC yield is now.

The current YTM number should be higher, with higher-yielding securities replacing those that matured during this time. This brings us to the distributions. As noted earlier, the payouts from this fund have been increasing in recent times, with a current yield of 2.4% (based on the most recent distribution and the current price of $73.85).

The distribution yield will catch up to the earnings or 30-day SEC yield of this fund as they typically pay out all their net earnings. So, we expect to see close to 5.5% distribution yield in about a year.

Verdict

The treasury rates started rising around the end of 2021 and the market expects the Fed funds rate to peak in May 2023. A duration of 2.7 years takes low interest risks, but that works both ways. In case the Federal Reserve actually starts cutting rates, this fund will benefit far less than one with a long duration. The fund is a good place to get a little income while taking very little credit or interest rate risk. Yes, you got a really poor return in the last 18 months, but if you held this 18 months back, you have no one but yourself to blame. With such a small actual yield back then, even a small duration risk hit the fund very hard. We are in different times now. Sure, we could see rates rise another 1-2% over the next 18 months. But with such a high yield to maturity, your odds of losing money over the next 18 months are close to zero. We still give this just a hold rating, simply because there are just too many opportunities to chase this one.

Please note that this is not financial advice. It may seem like it, sound like it, but surprisingly, it is not. Investors are expected to do their own due diligence and consult with a professional who knows their objectives and constraints.