VCIT - VCIT: The Right Bond ETF As We Head Into A Recession

2023-06-13 07:22:23 ET

Summary

• The Vanguard Intermediate-Term Corporate Bond Index Fund ETF (VCIT) offers a high yield and potential for appreciation.
• VCIT holds intermediate-term investment-grade corporate bonds, offering a low volatility way to take advantage of a slowing economy and potential recession.
• I rate VCIT a Buy, as it provides a good asset to own before and during a recession.

Vanguard Intermediate-Term Corporate Bond Index Fund ETF ( VCIT ) offers broad market exposure to 5-10 year investment-grade corporate bonds. According to Vanguard, VCIT aims to track "a market-weighted corporate bond index with an intermediate-term dollar-weighted average maturity". VCIT's yield has been brought up by all the recent rate hikes and it currently has a 30-day SEC yield of 5.3%.

This ETF offers not only a nice yield but I think it also has room for capital appreciation in the near future. The Fed's attempt to slow the economy hasn't worked as well as they would have liked and they may have to implement some further modest rate hikes in 2023. Because of this, I think it's a good time to switch from equities to bonds. Of all the different bond ETF types, ratings, and maturities, one of my favorites right now is VCIT.

VCIT's high-quality intermediate-term corporate bonds offer a relatively low-risk way to take advantage of the slowing economy and the pending recession. I rate VCIT a Buy.

Holdings

As its name suggests, VCIT holds intermediate-term corporate bonds. The bonds mature in 5-10 years and VCIT holds a good mix of durations within that range. If fact, the average maturity is exactly 7.5 years. This ETF holds a whopping 2,110 corporate bonds. Not a single holding makes up more than 0.5% of its AUM and the top 10 holdings barely make up over 3%.

VCIT holds bonds issued by many different sectors. About 41% of its holdings are bonds issued by the finance industry.

Although this may concern some after the recent stress financial companies have been under, VCIT makes sure all of its holdings are investment grade, typically A and BBB, easing default worries. The heavy proportion of A and BBB bonds clearly brings more credit risk than a portfolio with all AAA bonds, but it also gives it a higher yield, with a current SEC yield of 5.3%.

Why a recession is coming

My entire thesis relies on a recession in the near future. So before I discuss why bonds, specifically the bonds VCIT offers, are a good asset to own before and during a recession, I'll provide my reasoning on why I expect a recession.

The chart above shows the Fed's funds rate since FRED has tracked it. The gray bars represent recessions. Almost every gray bar comes after a rapid rise in interest rates. At the end of the chart representing the present day, we have a very rapid rise in rates, and time will tell, but I think it will be followed by a gray bar. Although rates aren't nearly as high as they were back in the 1980s, the recent rate hikes are still a big deal because The economy has gotten so used to near 0% rates. The current rate hikes also look awfully similar to the hikes preceding the 2008 recession, but the current rise is even larger and more rapid.

The Fed has been relatively aggressive with rates recently, raising them very quickly to a 15-year high. But the economy hasn't slowed down nearly as much as expected. Inflation is still coming in hotter than expected . SPY recently entered bull market territory. And finally, the payroll report for May came in almost twice what was expected.

The Fed needs to be more aggressive to stop the sticky inflation we are experiencing. Although it looks like the Fed will pause in June , they have hinted that they may continue to raise rates in 2023, and I'm confident they will. This will certainly push us into a recession.

Why hold bonds during a recession

Bonds are traditionally a place to store money and get low-risk income. In recent years, the US has had near 0% rates, and bonds lost a lot of their attractiveness, and they got hammered as rates rose dramatically over the past year. However, bonds now have a much more enticing yield and are poised to be a great asset as the economy heads into a recession. After the coming recession reduces inflation enough, the Fed will cut rates to stimulate economic activity in hopes of getting the economy back out of a recession. When rates go down, bond prices go up. So when rates are cut after a recession starts, bonds and bond ETFs appreciate. In every single recession since 1950, bonds have outperformed stocks and cash .

Why corporate bonds, why intermediate-term, and why VCIT

The reason why I favor corporate bond ETFs over government bond ETFs like IEF is simply the higher risk-higher reward. Corporate bonds carry more default risk, but as long as the corporate bonds are investment grade, I think the higher yield is worth the potential risk.

I'm a fan of intermediate-term corporate bonds right now because they are better than short-term and long-term bonds. Short-term bond ETFs like VCSH and IGSB are too dependent on the Fed's decisions. It's hard to know exactly when the Fed will pause and pivot, and because of how correlated short-term corporate bond yields are with the Fed funds rate, being wrong by a few months can really affect the return.

Long-term corporate bond ETFs like TLT and MBB don't pay enough right now due to the inverted yield curve. This is due to the fact that the market is pricing in the fact that within the next 10-30 years, rates will probably be low again. This makes intermediate-term corporate bonds a sweet spot right now. Intermediate-term rates are high because of raising rates, but not as dependent on the Fed's decisions as short-term bonds. And intermediate-term corporate bonds are more attractive than long-term corporate bonds because of the higher yield but shorter maturities.

Finally, the reason I choose VCIT over other intermediate-term corporate bond ETFs such as IEF is because of its ridiculously low expense ratio of 0.04%. The next leading intermediate-term corporate bond ETF, IEF, has an expense ratio of 0.15%, more than 3 times VCIT’s.

Conclusion

With over 2,000 individual holdings, VCIT offers broad market exposure to intermediate-term corporate bonds. There is a recession on its way, and I think that buying the intermediate-term corporate bonds that VCIT holds is one of the best ways to profit from this inevitable economic downturn. I rate VCIT a Buy.

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