VCLT - VCLT: Avoid Long-Dated Corporate Bonds

2023-03-07 10:58:41 ET

Summary

• Long-dated corporate bonds are in trouble due to a downward-sloping yield curve, which might result in fixed-income investors shortening their portfolio durations.
• Although the Vanguard Long-Term Corporate Bond Index ETF has AAA exposure, most of its constituents are BBB-rated and partake in cyclical industries.
• A linear regression shows that the exchange-traded fund possesses negative active returns and a diminished IR ratio, revealing questionable portfolio management.
• The Vanguard Long-Term Corporate Bond Index ETF's dividend is compelling. Yet, it might not be enough to phase out the ETF's price risk.
• A potential macroeconomic recovery is in the cards. However, we don't think long-dated corporate bonds will capture economic inflection points unless they possess significant magnitude.

This is probably not what you want to hear, but your long-dated corporate bonds are in danger. This includes the Vanguard Long-Term Corporate Bond Index ETF ( VCLT ) .

Unfortunately, the yield curve and credit spreads are not playing ball, which has added pressure to diversified long-dated bond portfolios such as the Vanguard Long-Term Corporate Bond Index ETF.

This article describes how the yield curve, market risk premiums, and cyclicality could influence the Vanguard Long-Term Corporate Bond Index ETF. Moreover, a trade-off is considered between the fund's potential carry and price returns.

Although we are not advocating a short position, our reasonable basis tells us that the Vanguard Long-Term Corporate Bond Index ETF is a no-go; here is why.

Assessing Long-Dated Corporate Bonds

Market risk premiums are chained. Therefore, it is necessary to start with the basics before determining a corporate bond's risk premium. And there is no better way to do that than observing the U.S. Yield Curve, which illustrates a weighted average of implied spot rates.

A downward-sloping yield curve suggests that long-term interest rates will be lower than current rates, implying that an economic event might occur in due course, consequently derailing bond returns.

A healthy yield curve is usually moderately upward-sloping. Portfolio managers exploit such a situation by "rolling down the curve" , which is deployed by borrowing short-term and buying long-dated bonds. However, as visible in the diagram below, short-dated yields are higher than long-term yields, which means investors are likely to buy short-term bonds and sell long-dated fixed-income securities (at the moment).

The Vanguard Long-Term Corporate Bond Index ETF tracks the performance of the Bloomberg U.S. 10+ Year Corporate Bond Index, meaning it is constrained to long-dated fixed-income assets. Thus, it is currently in an unfavorable position for the reasons mentioned before.

Let us move along the golden thread and elaborate on corporate bond risk premiums.

A corporate bond has a few prevalent risk premiums, namely: interest rate uncertainty, inflation, inflation uncertainty, and credit spreads (which includes liquidity, tax, and company-specific risks). Considering the mentioned risk factors, I think we can all agree that interest rate policies and U.S. inflation remain very uncertain. In our opinion, this adds to bond-related risks, which, if intertwined with the yield curve, could result in higher returns for short-dated bonds but lower returns for long-dated bonds.

Furthermore, as displayed below, credit spreads hit an inflection point on February 7th, shortly before the January CPI report was unveiled, which conveyed higher-than-anticipated inflation. In our opinion, these spreads will remain elevated for as long as macroeconomic variables are unstable.

Collectively, the data suggest that systemic risk is rife and that the Vanguard Long-Term Corporate Bond Index ETF is in danger of further drawdowns.

VCLT's Portfolio Assessed

Let us look at the Vanguard Long-Term Corporate Bond Index ETF's portfolio to garner an enhanced understanding of the product.

The ETF's portfolio contains approximately 2700 instruments. Thus, assessing some of its holdings in isolation would make no sense as the ETF's company-specific risks are diversified and phased out of the risk equation (this is evident by observing the portfolio's beta coefficient of 1 ).

Although not suitable for security-specific analysis, the portfolio's credit rating composition and its industry exposure do speak volumes. The Vanguard Long-Term Corporate Bond Index ETF is loaded with BBB corporate bonds, exhibiting an average duration of 13.3 years. In our view, the ETF's composition is unfavorable as BBB corporates with long-dated maturities are exceptionally sensitive to credit risk, and as displayed before, the yield curve and the credit spread curve spell trouble.

Another big no for us is the ETF's exposure to financials and industrials. Even though we are bullish on banks and industrial stocks (and bonds) for 2023, we think long-dated exposure is dangerous due to the market's belief that a recession is pending.

Industrials and financials are exceptionally sensitive to a recession. Based on the bond market, both are tactical plays and very far adrift from buy-and-hold opportunities.

Lastly, a closer look at the fund's managerial prowess conveys a disappointing picture. The Vanguard Long-Term Corporate Bond Index ETF's Sharpe and Sortino ratios are in positive territory, meaning the fund's volatility-adjusted returns and volatility-adjusted drawdown management are in check; however, its negative active return, negative information ratio ((IR)) and excess kurtosis paint an underwhelming picture.

As mentioned before, the ETF tracks the Bloomberg U.S. 10+ Year Corporate Bond Index. The Vanguard Long-Term Corporate Bond Index ETF's negative active return means it underperforms the index, and its deficient IR reveals that investors are not receiving managerial value for their money ( the IR ratio measures a portfolio manager's skill ).

Collectively, we cannot deem this ETF as an efficiently managed vehicle.

Expenses and Distribution

A primary advantage of ETFs is that they protect investors against non-transactional expenses. Therefore, one cannot fault VCLT's expense ratio of merely 0.04% , which is in line with the average U.S.-based fixed-income ETF's cost .

On top of its favorable cost basis, the ETF pays attractive dividends. With a monthly distribution, the Vanguard Long-Term Corporate Bond Index ETF's historical annual dividend yields range between 2.98% and 5.31%.

Could VCLT's dividends phase out its price risk? Yes, it is possible.

A Fundamental Counterargument

Not everything is doom and gloom for VCLT. In fact, we think the ETF is a 70% sell, 30% buy scenario. Let us run through the 30%.

The ETF hosts various A-rated corporate bonds, spanning nearly 40% of its portfolio. Although A-rated bonds are sensitive to the yield curve, they tend to possess less effective duration than BBBs, meaning this ETF somewhat protects investors against unfavorable risk premiums.

Furthermore, many of our previous articles have outlined an improved economic outlook. Suppose higher-than-anticipated GDP growth in the U.S. , abated recession in the EU, and re-openings in China were to sustain. In that case, the general bond market outlook will improve, leading to support for the Vanguard Long-Term Corporate Bond Index ETF.

Final Word

Although we are bullish on short-term bonds and think cyclical equities will succeed in the short term, we remain bearish on long-dated corporate bonds and buy and hold equity portfolios.

With the yield curve in mind, the Vanguard Long-Term Corporate Bond Index ETF's long-dated BBB corporate bond exposure is unfavorably aligned. In addition, inflation and credit spreads have recycled their suspicions of a recession as inflation remains unstable.

Although the ETF provides sound dividends, a managerial perspective implies that the Vanguard Long-Term Corporate Bond Index ETF is poorly managed, with an active risk deficit being front and center to our concerns.

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