Why I Expect VCLT To Underperform During The Second Half Of The Year – Vanguard Long-Term Corporate Bond Index ETF (NASDAQ:VCLT)

Overview

The Vanguard Long-Term Corporate Bond ETF (VCLT) is an ETF that invests primarily in investment-grade corporate bonds with above-average exposure to interest rates. The ETF is a passively managed fund that seeks to track the Bloomberg Barclays U.S 10+ Year Corporate Bond Index. The fund has a yield to maturity of ~4.4% and a low expense ratio as one would expect with a Vanguard managed fund at 0.07%, which equates to a net yield of ~4.3%. With a 4.3% yield and an average effective maturity of a little under 24 years, the fund is yielding roughly 165 bps over a similar-maturity Treasury bond. However, despite the yield-pick up over Treasuries, I expect this ETF to underperform over the remaining part of the year.

Interest Rate Risk and the 10-Year

The interest rate risk that VCLT contains must be understood. The ETF contains mostly long-term bonds, and as a result, the fund has above-average exposure to changes in interest rates relative to other popular fixed-income ETFs. The fund has an effective duration of 13.5 years, which means if rates shift up 1%, the value of the underlying bonds in the ETF will decrease 13.5%. The opposite is true if rates shift down 1%. Over the past six month, the 10-year Treasury rate has steadily decreased and bonds with longer durations have outperformed similar collateral with shorter durations. VCLT is no exception and has performed very well due to its above-average duration.

Source: Bloomberg

However, given the recent rally in rates, it is not unreasonable to think that Treasury rates could rebound. This is especially true given the current health of the US economy. Jerome Powell emphasized in his press conference on March 20^th that the economy is in a good place. The job market is strong and wage growth is moving higher. Additionally, the Fed’s wait-and-see approach may allow inflation to rise above its 2% target before another rate move. This could cause the yield curve to steepen, with long-term rates moving higher.

For these reasons, I would expect long-term rates to tick back up toward the second half of the year. However, this is not a certainty and there are notable headwinds. U.S. sovereign debt is yielding at significantly more attractive levels than other country’s sovereign debt, which has been putting downward pressure on rates. For example, 10-Year government bond yields for Germany and Japan are negative, and the U.K 10-year is a hair over 1%. Another factor that could drive rates down further is volatility, just like we saw at the end of 2018, and recently in the past month. If we enter a period with prolonged volatility, a flight-to-quality would most likely follow which would continue to force yields lower.

Despite the potential for rates to continue to rally, I am decreasing my exposure to interest rates by shifting to shorter-duration bonds and ETFs. There are still yield pickup opportunities that can be found along the short-end of the curve without having to take on the interest rate risk that VCLT contains.

Credit Spreads

Since corporate bonds carry more risk than Treasuries, they are classified as a spread product and are thus impacted by movements in spread. Spreads can be measured in a number of ways, but my preferred measure is option-adjusted spread (“OAS”, “spread”). The credit quality composition of VCLT is below.

Source: Vanguard

Since the fund is weighted heavily toward Baa (BBB) and A rated bonds, it makes sense to focus on spreads in those credit tiers. As shown in the charts below, towards the end of 2018, spreads widened and corporate bonds were negatively impacted. As volatility subsided, the market’s appetite for risk increased, demand for corporate bonds (along with other fixed-income sectors) increased, spreads tightened, and prices increased. The mean and standard deviations in the charts below represent historical data going back to the beginning of 2010.

Source: Federal Reserve Bank of St. Louis

As you can see, current spread levels are sitting just above one standard deviation below their mean. Although spreads have tightened substantially since the beginning of the year, the recent widening still offers a relatively fair entry point for A rated corporates. BBB corporates are sitting at some of the most attractive levels they’ve been at over the past two years.

Source: Federal Reserve Bank of St. Louis

Based on the current valuation of investment-grade corporate bonds and the current state of the U.S. economy, I still believe there is value in the sector. Given the Fed’s steady monetary policy, I don’t expect spreads to move significantly in either direction barring a flare-up in geopolitical risk. However, the excess yield that is earned over Treasuries is a good buffer against a modest widening in spreads.

Conclusion

In conclusion, I don’t believe the investment-grade corporate sector is cheap, but I also don’t believe it’s expensive, and from a relative value perspective there still appears to be opportunity. However, I don’t believe now is the time to increase exposure to duration, especially given the flat yield curve. For this reason, I do not have any exposure to VCLT (or long-term corporate bonds), but do have exposure to corporate bonds with shorter durations. As with any investment strategy, a diversified approach is recommended.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.