(This article was co-produced with Hoya Capital Real Estate.)
In my most recent article here on Seeking Alpha, I reviewed Vanguard Short-Term Bond ETF (BSV), explaining why BSV is the largest holding in my personal portfolio.
This article was consistent with most of my previous writing on bonds, which largely focused on the shorter end of the spectrum. In addition to BSV, I have covered total US market bond ETFs such as Vanguard Total Bond Market Index Fund ETF (BND) and iShares Core US Aggregate Bond ETF (AGG).
At the same time, here is how I concluded this article on BSV.
In these very interesting times, I am watching the direction of interest rates and the actions of the Fed very closely.
You see, right now my personal weighting is around 15% in BSV, 10% in AGG and 3% in iShares 20+ Year Treasury Bond ETF (TLT). As we get closer to a point where I think the Fed is done with interest rate increases, I might consider reducing my weighting in BSV in favor of slightly heavier weightings in the other 2 ETFs.
Why? For two reasons. First, to potentially reach a slightly higher level of income. Second, since bond prices move inversely to interest rates, there could be a point where the potential for capital gains is higher in longer-term ETFs.
Along the same lines, even more recently I have encouraged investors to keep an eye on bonds, suggesting that the risk/reward proposition is gradually improving.
All this train of thought led me to take my very first look at Vanguard Long-Term Bond ETF (NYSEARCA:BLV).
Why is this my first BLV review?
So far, I haven’t had much interest in a longer-term offering such as BLV. Due to the historically low interest rate environment we have found ourselves in for years, I have built my personal portfolio around a mix of US and international stocks buffered with an allocation to shorter duration bonds . The goal of my bond allocation was to provide some measure of current income, while simultaneously protecting my portfolio in the event of a severe downturn.
In contrast, I felt that if we were to find ourselves in a rising interest rate environment, the longer end of the duration spectrum carried too much downside price risk to compensate for the slightly higher income that these obligations provided.
This view was certainly not wrong. Take a look at the YTD price performance for BLV, compared to BSV and BND.
In summary, while all 3 holdings are down significantly in the worst year for bonds in over 40 years, BLV is by far the worst performer. Admittedly, I have no regrets about omitting this ETF from my portfolio so far.
However, we now find ourselves in a changing environment. In one of my most recent articles here on Seeking Alpha, I explained why what I call “the world of 4,818” faces an uncertain future. One of the reasons for this is that Jerome Powell stated unequivocally that “the Fed’s overriding objective right now is to get inflation back to our 2% target.”
After the release of August’s CPI report, which rose 8.3% from a year earlier despite lower gasoline prices, almost all observers expect the Fed implement another 0.75% increase, and some suggest a full 1% increase to beat the curve.
I will briefly summarize in the conclusion what this could mean for BLV investors. For now, however, let’s take a look at the fund itself.
Vanguard Long Term Bond ETF – dig into
Particularly in this area of your portfolio, where your primary goal is to generate income rather than capital gains, it’s important to control your spending. With an ultra-low expense ratio of 0.04%, BLV certainly meets that test.
From Vanguard’s summary prospectus for BLV, here’s some more color regarding the underlying index it tracks.
Main investment strategies
The Fund uses an index investing approach designed to track the performance of the Bloomberg US Long Government/Credit Float Adjusted Index. This index includes all medium and large issues of US government bonds, investment grade corporate and international investment grade bonds denominated in dollars that have maturities greater than 10 years and are publicly issued.
From Vanguard’s webpage for BLV, here’s a more detailed breakdown of BSV’s makeup. First, by credit quality.
The focus on treasury bills gives this portfolio a high quality credit profile. In addition to the 44.11% allocation to US government bonds, a further 1.63% is AAA rated, meaning around 46% of the fund is invested in AAA bonds.
At the other end of the spectrum, however, please note that BBB-rated bonds are the second most weighted segment in terms of credit quality. This is the lowest quality rating. It is therefore clear that the fund does not eliminate credit risk, but it should hold up better than most when credit spreads widen. The balance of the fund is made up of relatively safe bonds rated AA and A.
Second, we turn to effective maturity.
The average effective maturity of the fund is 23.1 years and the average duration is 15.0 years. If you are unclear on the difference between maturity and duration, I explain it in this article.
Summary & Outlook
Similar to my recent article on BSV, I will end this article with a section called “summary and outlook” as opposed to ” summary and conclusion.”
To explain why, let me repeat a little excerpt from that previous article that I featured in the opening of this article.
As we get closer to a point where I think the Fed is done with interest rate increases, I might consider reducing my weighting in BSV in favor of slightly heavier weightings in the other 2 ETFs.
As I hope I have explained well in this article, interest rate risk forms an important component of your assessment of BLV, given its long-term maturity and duration profile. It is precisely this risk that materialized last year, when prices fell by around 25% since the beginning of the year.
But, as investors, we need to look forward, not backward.
As I have presented in this article, there seems to be a chance that the Fed, after several significant increases in interest rates, will take a break towards the end of 2022 to measure the effects on the economy. It is at this point that I feel that most, if not all, of BLV’s interest rate risk may already be priced in.
As I finalize this article, the 30-day SEC yield on BLV sits at 4.51%. So, if we assume a slight further decline in prices until the end of 2022, this return could approach the 5% mark. In other words, even if there are further slight price drops, this healthy yield will cover you to some extent. On the other hand, if interest rates stabilize and even decline in a recession, you could reap capital gains over time while earning that 5% return in the meantime.
Here is one last data point to consider. In addition to interest rate riskI indicated that BLV exposes investors to a measure of credit risk. To what extent are investors compensated for this risk?
To answer that question, let’s take a look at the only long-term bond ETF I currently hold in my portfolio, iShares 20+ Year Treasury Bond ETF (TLT).
Here is from the iShares webpage the features of the wallet for TLT.
Let’s quickly evaluate BLV vs. TLT. First, as can be seen, TLT’s 30-day SEC yield currently stands at 3.46%, compared to BLV’s 4.51%. Second, please note that the effective maturity and term of TLT is approximately 2 years longer than that of BLV.
In other words, if you decide to accept the higher level of credit risk associated with BLV, you are rewarded with approximately 1% additional return and slightly lower interest rate risk.
What do you think? It’s an interesting dilemma isn’t it? As December approaches, I plan to go back and evaluate adding BLV to my portfolio.
I’d love to hear from you in the comments section below!