VCIT - VCIT: Strong Performance So Far But IG Bonds Are Just Getting Started

Summary

• VCIT is sitting on total returns of 7.2% since we initiated our "Strong Buy" rating on 25 October 2022. A respectable return for an investment-grade bond ETF in less than 3 months.
• When we initiated coverage of VCIT and invested in it, we invested in the fundamental idea that inflation would ultimately be transitory.
• Our big-picture view of the economy hasn't changed, so we are maintaining our "Strong Buy" rating.
• Expectations for normalization of Fed monetary policy should drive 5-10 year investment-grade bond yields back to the 3.5-4.0% range from VCIT's current yield-to-maturity of around 5.3% (as of 30 November).
• Given that we have yet to see a meaningful recovery in fund flows into fixed income, this means that there is still ample room for VCIT to build on its recent gains.

Our core view that inflation has peaked and will continue to moderate in the coming months is playing out nicely. Not only is the Cleveland Fed's latest inflation nowcasting indicating that year-on-year Core PCE has cooled from 4.7% in November to 4.52% in December, but inflation expectations have also moderated significantly.

Breakeven rates, which gauge market expectations for inflation, have fallen back to the 2021 lows, an indication that market sentiment is confident that the Federal Reserve's aggressive monetary tightening will stem inflationary pressures. With disinflation becoming more certain for investors, financial markets are already preempting the Fed, with bond yields starting to drift lower since November and the futures market pricing in the probability of a Fed pivot by the end of 2023.

Consequently, our bullish position on the Vanguard Intermediate-Term Corporate Bond ETF ( VCIT ) is now sitting on total returns of 7.2% since we initiated our "Strong Buy" rating on VCIT on 25 October 2022. A respectable return for an investment-grade bond ETF in less than 3 months.

A Quick Note On Philosophy

We think it may be worthwhile to digress a little to discuss the investment philosophy underpinning our bullish view on VCIT, and why we are maintaining our "Strong Buy" rating.

Perhaps at this point, some investors may be experiencing the temptation to take profit on VCIT over the fear of potentially giving back those gains. Or perhaps some investors who clearly saw the opportunity but missed the move may be thinking that they should wait for a better entry point.

However, these short-term market timing considerations were never a part of our investment decision-making process from the beginning. From our point of view here at Stratos Capital, what matters in achieving consistent investment performance over time, is to ignore what the market is going to do in the short term, and to focus on executing a well-defined strategy with discipline.

Therefore, it is absolutely crucial to investigate the real reasons driving one's investment decisions and to question if those reasons for investing have changed. Did we invest in VCIT so that we could potentially capture quick single-digit gains? Or did we invest because we saw a fundamental reason for VCIT to outperform over a medium-to-long-term horizon and that staying invested would add value to overall portfolio performance over several years?

Why We Invested In VCIT

When we initiated coverage of VCIT with a "Strong Buy" rating and invested in it, we invested in the fundamental idea that inflation would ultimately be transitory and that the Fed's aggressive monetary tightening would be sufficient in keeping inflation expectations anchored. Furthermore, the overwhelming pessimism surrounding the Fed's ability to successfully tame inflation had driven yields to really attractive levels then.

The biggest question we had to answer was: are bond yields going to climb much higher and stay high for an extended period of time because we are back in an era of hyperinflation?

Despite the dire warnings issued by several prominent economists that the U.S. economy was at risk of returning to the stagflationary era of the 1970s, we saw no real evidence that the nature of the low inflation and low rates environment of the past two decades had fundamentally changed.

Too often, the doomsayers in the financial media would evoke memories of hyperinflation in the 1970s simply by pointing to how inflation in 2022 had risen to the highest level in decades, and how inflation eventually got worse during the 1970s. But of course, inflation was at the highest levels in decades: that is because we just experienced a few decades of low inflation! And there were real structural changes since the 1970s that created this low inflation and low rates environmental that lasted for so long until the pandemic hit.

The evidence we gathered was also telling us a different story. That the inflationary pressures had few similarities to the 1970s, and that inflation was mostly driven by post-pandemic realities of disrupted supply chains and pent-up demand for specific goods and services as economies reopen. There were few signs of an overheating economy of the likes of the 1970s, but many signs of a strong, healthy economy that was bouncing back from the pandemic.

Our View Hasn't Changed, And So Is Our Rating On VCIT

As readers may have guessed by now, recent developments haven't changed that much since October. From monthly CPI and PCE readings indicating cooling inflation to a resilient labor market, and commodities prices trading well below their June peak to a Fed that has been consistent with its communication on monetary policy. So our big-picture view of the economy hasn't changed.

Meanwhile, we have yet to witness a recovery in fund flows into the bond markets. After the bond market suffered one of its worst years in recent memory, investors have broadly maintained a cautious stance towards fixed income. According to data compiled by Bloomberg Intelligence , as of 15 December 2022, investors have pulled US$480 billion out of bond mutual funds while bond ETFs have only attracted inflows of US$184 billion last year, much lower than the over $200 billion of inflows recorded in 2021 and 2020.

Our conviction on VCIT is partly driven by our expectation that investment-grade bonds would deliver outsized returns in the coming years as institutional investors return to this asset class in force. As we continue to see increasing evidence that inflation is on track to meet the Fed's 2% target sometime by the end of 2023 or early 2024, expectations for normalization of Fed monetary policy should drive 5-10 year investment-grade bond yields back to the 3.5% - 4.0% range from VCIT's current yield-to-maturity of around 5.3% ( as of 30 November ).

Given that we have yet to see a meaningful recovery in fund flows into fixed income, this means that there is still ample room for VCIT to build on its recent gains. Indeed, we think VCIT's recent outperformance is just getting started.

So What Should Investors Do?

For investors who are already sitting on gains on VCIT, we see no reason to take profit at such an early stage. The upside potential for VCIT far outweighs the downside risks.

And for investors who have yet to enter, we think waiting for a better entry price risks being completely sidelined should a pullback in price never materialize. If you like the view, just take the trade and ride it. Don't time it.

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