SGOV - My Top 3 ETFs As We Likely Head Into A Recession

2023-07-10 01:13:08 ET

Summary

• I predict a recession due to high-interest rates and suggest three ETFs to own in this scenario: SGOV, VCIT, and VT.
• SGOV is a low-risk treasury bond ETF with a high yield, VCIT holds intermediate-term corporate bonds with a high yield and potential for capital appreciation, and VT tracks the global stock market.
• These ETFs can be beneficial whether used individually or together, depending on an investor's risk tolerance and investment duration.

Recession fears have loomed over investors since the start of 2022. Since then, we have entered and exited a bear market, but there has still been no recession. I, as well as plenty of others, still see this recession coming in the near future. Before I give my top three ETFs to own as we head into a recession, I will briefly state my reasoning for predicting this recession.

The coming recession

Interest rates are at an over two-decade high, and they are almost certainly going to go up even further. Fed Chairman Powell has told investors to expect 2 more hate hikes in 2023. The Fed seems willing to risk pushing the economy into a recession to lower inflation. Despite the Feds' efforts, the economy has continued to boom. In June , wages rose and unemployment fell, causing investors to believe that the Fed isn't bluffing and will likely continue to raise rates until the economy slows down.

ETF #1: SGOV

iShares 0-3 Month Treasury Bond ETF (SGOV) is an ultra short-term treasury ETF. It only holds treasury bonds with 0-3 month maturity times. These types of treasuries are ultra-low risk and are often considered a cash alternative. The chart below illustrates how low-volatility this ETF really is. It depicts the total return from SGOV and BND , Vanguard's total bond market ETF, since SGOVs interception.

What makes SGOV so attractive right now is that its 30-day SEC yield is 5.17%, which is higher than many of its riskier peers.

A 5.17% yield for practically zero risk is already very enticing, but this yield is likely to go up even more as the FED continues to raise rates. As every bond investor knows, when rates go up, bond prices go down. However, because of SGOV's low duration, the capital depreciation will be minimal as rates continue to rise.

What could go wrong/drawbacks

Just as SGOV won't depreciate much when rates rise, the inverse is also true in terms of appreciation when rates are cut. I don't think this is an issue to worry about now. We haven't even gotten past the rate hike stage and the information we have been given by Fed Chairman Powell tells us rate cuts won't start for a couple of years.

Why SGOV over its peers

SGOV is a cheap ETF. Its expense ratio is only 0.07%. SGOV's much larger competitor, SPDR Bloomberg 1-3 Month T-Bill ETF (BIL), had an expense ratio of 0.14% as well as a lower yield.

ETF #2: VCIT

Vanguard Intermediate-Term Corporate Bond Index Fund ETF (VCIT) holds investment-grade intermediate-term (5 to 10-year) corporate bonds. Because VCIT's holdings are in corporate bonds rather than treasures, VCIT is riskier and more volatile. The holding of intermediate bonds also adds moderate risk, with interest rate risk falling between that of short-term and long-term corporate bonds. The image below shows its total return compared to BND.

As the chart illustrates, VCIT is rather volatile, but I think its impressive 30-day SEC yield of 5.38% makes it worth it. Along with this high yield, it does offer capital appreciation potential when rates get cut. While rates won't be cut for a while, investors can benefit from the high yield as they wait.

I think VCIT and SGOV can work really well together in a portfolio. While there are many ways to use these two ETFs to complement each other, I will suggest my two favorites. If you are an investor who tries to time the market, owning SGOV now and switching to VCIT when rates reach their max would let you get the high yield and very low risk that SGOV offers now and then benefit from the capital appreciation of VCIT when rates get cut. If you would rather not time the market, owning both right now and slowly switching from SGOV to VCIT over the next few years would provide you with a high yield and a chance of capital appreciation while limiting some market timing risks.

What could go wrong/drawbacks

If you own VCIT and rates go up more than expected, VCIT will depreciate more than a safer ETF like SGOV. Also, if the coming recession is very severe, it could cause more corporate bonds to default, hurting VCIT.

Why VCIT over its peers

There aren't many intermediate corporate bond ETFs. VCIT offers exposure to high-quality intermediate corporate bonds and has an expense ratio of only 0.04%.

ETF #3: VT

Vanguard Total World Stock Index Fund ETF (VT) tracks the entire world market. You may be surprised to see an equity ETF on this list, but I believe having some equity market exposure at all times is a good idea for most investors, although how much obviously depends on risk tolerance, age, and your plans for retirement. VT offers market-cap-weighted exposure to the entire world stock market. I think it's important for investors to remember John Bogle's (the late founder of Vanguard), "relentless rule of humble arithmetic ". This "rule" is simply acknowledging that the market is hard to beat and that " the return of the total market must equal the average return of all investors. To the extent someone gets more return, someone else must get less. It's a zero-sum game." Consistently being the person who gets a higher return is extremely hard, even for full-time fund managers.

I'm not saying it's impossible. We are all here "seeking alpha" and I'm even recommending ETFs that I believe will beat the market. Many economists have been predicting this recession for a long time and it hasn't come. Investing is all about diversification and managing risk. While I believe that the market is overvalued and a recession is coming, investors as a whole think that the market is fairly priced. While I believe a portfolio of VCIT and SGOV will outperform the market, I also understand that I may be wrong. While I take my shot at outperforming the market, owning VT lets me know that I still own something that is priced by all investors. A little humility can be a valuable thing. The amount of VT that should be in your portfolio depends on how likely you believe a recession will be and your risk tolerance.

What could go wrong/drawbacks

If there is a severe recession, VT will suffer. Equities are risky and very sensitive to economic conditions. However, if you have a longer investment outlook, this is less of an issue. ??The recession will eventually end, and it's challenging to know when the market has bottomed, so I like to always have some money in equities. As the famous saying goes, time in the market always beats timing the market.

Why VT over its peers

Unlike S&P 500 ETFs, VT gives exposure to non-US equities and holds large, mid, and small-cap stocks. VT holds almost 10,000 stocks and has an expense ratio of only 0.07%. This would be near impossible to replicate without devoting a lot of time. It is definitely worth the expense ratio.

Conclusion

The three ETFs I'm recommending as we approach a recession (SGOV, VCIT, and VT) don't have to be used together. You can benefit from them whether you choose one or all three. Portfolio allocation should be determined by risk tolerance and how long you plan on holding the asset.

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