IGSB - VCSH: You Should Put Your Cash Elsewhere

Summary

• VCSH invests in short-term investment grade corporate bonds in the U.S.
• The fund faces more downside risks than U.S. treasuries.
• VCSH’s capital appreciation potential is limited in the near term.

Overview

Vanguard Short-Term Corporate Bond ETF ( VCSH ) has a portfolio of short-term investment grade corporate bonds. The fund has recorded a much less loss compared to longer-term duration bond funds in the same category. However, VCSH is less secure than U.S. treasuries especially in an economic downturn. As we may be heading towards an economic recession, VCSH may not be the best choice to own. In addition, capital appreciation appears to be limited in the near-term as the Federal Reserve has repeatedly stated that they will not be lowering the rate this year. Hence, we think investors may want to put the cash elsewhere.

Fund Analysis

VCSH delivered better results than other long-term investment-grade bonds in 2022

Last year was a difficult year for bond investors. In 2022, VCSH registered a total return of negative 5.71%, the worst since its inception in 2009. The fund's annual returns were usually between low to mid-single digits in the past and the fund has generated 11 consecutive years of positive returns prior to 2021.

VCSH's poor return last year was not the worst. Funds with longer duration bonds have much more severe results. For example, Vanguard Long-Term Corporate Bond ETF ( VCLT ) and Vanguard Long-Term Bond ETF ( BLV ) delivered negative total returns of 25.73% and 27.20% respectively. The reason behind this difference is because bond prices are sensitive to rate changes and the sensitivity depends on the bond's duration. Since long-term bonds have a longer duration before maturing, any rate changes will have a much larger impact than shorter duration bonds. VCSH's average duration year is only 2.7 years. Hence, the magnitude of impact on its fund price is much smaller than longer-term bonds. For reader's information, VCLT and BLV have average duration years of 13.3 years and 14.5 years respectively.

However, owning VCSH may not be the best idea in 2023

Despite VCSH's better performance against its longer-duration peers over the past year, we do not think owning this fund is a good idea this year for the following reasons:

1. A large proportion of VCSH's portfolio belongs to lowest grade investment grade bonds.

Although all of the bonds in VCSH's portfolio are investment grade bonds, 44.7% of the fund consists of BBB rating bonds. These are bonds that belong to the lowest grade investment grade bonds. These bonds are more susceptible to being downgraded especially when facing business headwinds. Once downgraded, their bond prices will inevitably drop and thus impact the net asset value of the fund.

2. VCSH will most likely underperform treasuries in a recessionary environment

Although VCSH's portfolio of investment grade bonds are quite secure, it is still not as solid as owning U.S. treasuries. The U.S. government has never defaulted in their entire history and therefore is a safe haven for investors during financial turmoil. This may not be an issue when the economy is prospering but in an economic downturn, investors will flock into U.S. treasuries to seek shelter.

Below are three charts that illustrates this. The top is VCSH's price chart since its inception. The middle is VCSH's peer iShares 1-5 Year Investment Grade Corporate Bond ETF ( IGSB ), and the bottom is Vanguard Short-Term Treasury ETF ( VGSH ). During the recession in 2020, investment grade corporate bond funds such as VCSH and IGSB saw their fund prices drop sharply. The same was true for IGSB in the Great Recession in 2008/2009. On the other hand, treasury fund VGSH's share price was quite solid during the 2020 pandemic, even jumping to a record high quickly. Since our base case is that there will be a recession coming up, we think it is best to be cautious and seek for safety instead. We will explain more in our next point.

3. Capital appreciation is limited in the current environment vs longer-term bonds

While inflation has dropped substantially, January's headline CPI growth of 6.4% was only down slightly from December's 6.5%. The Federal Reserve's preferred measure for CPI growth excluding food, energy and rent inflation has remained unchanged at 4.1% for 3 consecutive months since November 2022. In addition, a strong job market and a record low unemployment rate means that the Federal Reserve still has a long way to go to combat inflation and that any rate drop in the near-term is very unlikely. The longer that the rates stay elevated, the more likely that the economy will be tipped over to a recession.

Because the rate is likely not going to go down at least in 2023, there isn't going to be much room for capital appreciation. In addition, VCSH's short duration bonds are less sensitive to rate changes. Hence, the room for capital appreciation is already quite small. Despite all these, investors can still earn an attractive yield of 4.9%

Should you own VCSH now?

Based on your analysis, an investment in VCSH does not offer enough protection than owning solely treasury funds such as VGSH especially in an economic downturn. Any capital appreciation is likely limited especially for short duration bond funds such as VCSH. Therefore, we do not think investor should consider owning this fund right now. Even parking your cash at VCSH may not be the best idea as short-term treasury funds offers better safety in an economic downturn.

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