VCLT - VCLT: Another Buying Opportunity

2023-05-18 08:35:22 ET

Summary

• The Vanguard Long-Term Corporate Bond ETF has returned over 10% in total return terms since I last wrote on it in October, but the recent pullback is another buying opportunity.
• While the yield to maturity on VCLT has declined from 5.9% in October to 5.4% today, inflation expectations and equity yields have also fallen, further improving its relative attractiveness.
• The two main risks come from a credit crunch or renewed rate hikes which could occur if tech stocks continue their rally.
• However, the elevated yield provides ample compensation for such risks, and I expect VCLT to outperform its current 5.4% yield to maturity over the coming months and years as UST yields move lower.

Since I last wrote about the Vanguard Long-Term Corporate Bond ETF (VCLT) in late-October , the ETF has returned over 10% in total return terms, thanks to a slight narrowing in credit spreads and long-term US Treasury yields. While the average yield to maturity on the ETF has declined from 5.9% in October to 5.4% today, the dip in VCLT seen over recent days represents another buying opportunity. The fall in inflation expectations has improved the outlook for long-term Treasuries, while credit spreads are elevated relative to the yields available on US stocks.

The VCLT ETF

VCLT holds a broad portfolio of long-term investment-grade corporate bonds and tracks the Bloomberg US Long-Term Bond Index. With a weighted average maturity of 23 years and a duration of 13.2 years, the fund is highly sensitive to interest rate changes. Credit risk is relatively low credit risk, with slightly over half of the fund's holdings in A-rated credits or higher, resulting in a spread over equivalent US Treasuries of 1.7%. The ETF has significantly higher interest rate risk and volatility, as well as slightly higher credit risk, compared with the iShares iBoxx Investment Grade Corporate Bond ETF (LQD).

Real Yield Still Attractive, Particularly Relative To US Stocks

Over the past 7 months VCLT has risen by 7.5%, resulting in a 0.5 percentage point decline in the ETF's average yield to maturity. The fall in yield has been largely the result of falling long-term UST yields, which have fallen by around 40bps. However, over this period, we have seen long-term breakeven inflation expectations fall by 0.2pp, meaning the real long-term UST yields remain near multi-year highs.

Regarding credit spreads, while they have fallen by around 10bps since October, they remain extremely elevated relative to the yield on offer on US large-cap stocks, where free cash flow yields have fallen much further. The chart below shows the strong correlation between the long-term corporate credit spreads and the free cash flow yield on the S&P500 ex financials seen over recent years. Based on this correlation credit spreads should be around 20-30bps lower.

The next chart shows the S&P500 free cash flow yield relative to the yield to maturity on the Bloomberg US Long-Term Bond Index adjusted for inflation expectations. As equities are real assets that tend to rise in line with inflation, an apples-to-apples comparison required deflating the bond index yield to maturity by inflation expectations. This should give us an indication of what kind of returns to expect on both assets assuming no change in valuations. The yield spread has fallen back to its lowest level since the start of the 2008 global financial crisis.

Can VCLT Shrug Off A Credit Crunch?

The macroeconomic conditions are similar today as they were in 2008, with leading indicators of the economy slowing under the weight of rising debt servicing costs amid elevated interest rates. While VCLT was only issued in late-2009, we can see the performance of underlying Bloomberg US Long-Term Bond Index in the chart below. From its peak in early 2008 the index lost 24% by October that year, and we cannot rule out another credit crunch having a similar negative impact on VCLT. However, note that the long-term corporate bond index fully recovered all its losses over the following 8 months, and posted 5-year returns of almost 20% annually from its lows.

The kind of spike in credit spreads that we saw in 2008, caused by the freezing up of global bond markets following the Lehman Brothers collapse, and the incredible subsequent returns that resulted, are unlikely to be seen again in my view. While the Fed has surprised many with its willingness to let regional banks fail, the risk of a systemically important bank failure is extremely low, and as we have seen over the past 7 months, rising credit stress is likely to drive down interest rate expectations, supporting long-term Treasury prices.

A Continued Rise In Tech Stocks Poses A Potential Risk

A more salient risk, however, comes from a repeat of the late-1990s market trends. The refusal of the technology stock rally to cool under the weight of rising interest rates encouraged the Fed to continue hiking, which had a double negative effect on corporate bonds by driving down Treasury prices and credit risk simultaneously. That said, despite the significant underperformance seen during that period relative to the S&P500, the long-term corporate bond index still only lost 10% from its peak in January 1999 to its trough in May 2000. Furthermore, the scope for significantly higher real Treasury yields is much lower than it was back then due to the far greater public and private debt burdens. I therefore expect to see lower UST yields drive up VCLT over the coming months and year, allowing returns to outperform its current 5.4% yield to maturity.

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