USFR - VGSH: Sub-Par Yields From Inverted Yield Curve
2023-07-05 04:17:11 ET
Summary
- The Vanguard Short-Term Treasury ETF is not a good short or long-term investment due to its modest portfolio duration and sub-1% long-term average annual return, respectively.
- Despite the Federal Reserve pausing interest rate hikes, VGSH is unlikely to outperform floating rate yield vehicles like TBIL and USFR until the yield curve normalizes.
- I continue to recommend TBIL or USFR for cash allocation instead of the VGSH.
In November, I wrote a cautious article on the Vanguard Short-Term Treasury Index Fund ETF Shares ( VGSH ), suggesting it was neither a good short-term place to park cash nor a good long-term investment. In the short-term, its modest portfolio duration means the VGSH ETF will suffer duration declines every time the Federal Reserve increases interest rates. In the long-run, its sub-1% long-term average annual return is less than inflation so investors are losing purchasing power.
As expected, since my article, the VGSH ETF only returned 1.3% in total returns compared to 2.9% for the US Treasury 3 Month Bill ETF ( TBIL ) and 3.1% for the WisdomTree Floating Rate Treasury Fund ( USFR ), both of which I have personally recommended and hold in my own portfolio (Figure 1).
Figure 1 - VGSH has underperformed as expected (Seeking Alpha)
With the Federal Reserve recently pausing its interest rate hikes, does that mean the interest rate hiking cycle is nearing its end and the VGSH ETF will soon outperform floating rate yield vehicles like TBIL and USFR?
Brief Fund Overview
The Vanguard Short-Term Treasury ETF is a very simple fund to understand. It owns a portfolio of short-duration treasury bonds with weighted average maturity of 1-3 years, a portfolio duration of 1.9 years, and a portfolio yield to maturity of 4.5% (Figure 2).
Figure 2 - VGSH portfolio characteristics (vanguard.com)
The VGSH ETF currently has $27 billion in assets and charges a minuscule 0.04% expense ratio.
End Of Rate Hikes In Sight...
As mentioned above, the Federal Reserve recently paused its interest rate increases and many investors took it as a sign that the end of current interest rate hiking cycle maybe coming to an end. Traders and analysts widely expect at most one or two additional rate hikes before the cycle is over (Figure 3).
Figure 3 - Traders expect rate hikes to end soon (CME)
Given one of the headwinds against owning the VGSH ETF is duration losses from its 1.9 years portfolio duration, it is natural for investors to think that the coming end of the hiking cycle may reverse the headwinds against the VGSH ETF.
...But What About Higher For Longer?
However, before investors rejoice, they need to remember that the Fed's stated goal of maintaining tight monetary policy for an 'extended period of time' until inflation returns to its 2% target. In fact, Fed Chair Jerome Powell recently said at the ECB's Sintra Forum that he does not see inflation coming back to his 2% target until 2025.
What this means is that while the Federal Reserve may be done hiking interest rates, they are unlikely to cut interest rates anytime soon, barring a recession in the economy forcing their hand. According to the Fed's Summary of Economy Projections from the June FOMC, the committee sees short-term Fed Funds rate staying elevated at 5.4-5.6% at the end of 2023 and 4.4-5.1% at the end of 2024 (Figure 4).
Figure 4 - Fed Summary of Economic Projections (Federal Reserve)
For the VGSH ETF, this means investors will unlikely see any short-term boost from declining interest rates on the fund's 1.9 years duration.
Inverted Yield Curve Still Favours Treasury Bills
Furthermore, the term structure of the yield curve still favours holding treasury bills, as treasury bills are currently yielding over 5% while the yield on 2Yr and 3Yr treasuries are 4.9% and 4.6% respectively (Figure 5).
Figure 5 - Inverted yield curve favours treasury bills (worldgovernmentbonds.com)
The TBIL ETF is currently paying a forward distribution yield of 5.2% (July distribution of $0.2155786 on latest NAV of $49.87) while the VGSH ETF is only paying a forward yield of 3.3% (July distribution of $0.1586 on latest NAV of $57.48).
Until the yield curve normalizes (with short-term yields lower than long-term yields), it may make more sense for investors to allocate 'cash' to treasury bills rather than 2-Yr treasury notes.
VSGH Loses Purchasing Power In The Long-Run
Finally, it is important to re-emphasize that the VGSH ETF should only be considered for the cash portion of a portfolio. With long-term average annual returns sub-1%, investors are guaranteed to lose purchasing power even if inflation returns to the Fed's 2% target (Figure 6).
Figure 6 - VGSH historical returns (morningstar.com)
Conclusion
In conclusion, for my 'cash', I continue to recommend investors select floating rate investments like the TBIL or USFR instead of VGSH. Floating rate funds see a boost to their distributions every time the Fed raises interest rates (if we are to believe 1 or 2 additional rate hikes are in the cards) while any interest rate increases will cause small duration losses to VGSH's NAV.
On the other hand, even if the Fed is finished with raising interest rates, they may not cut interest rates any time soon. As long as the yield curve remains inverted, floating rate funds will deliver higher yields than VGSH. For example, the TBIL ETF is currently paying a forward 5.2% distribution yield while VGSH is only paying a 3.3% forward yield.
Finally, in the long-run, investors in the VGSH ETF will lose out to inflation. So allocations to VGSH should only be made on 'idle' cash.
For further details see:
VGSH: Sub-Par Yields From Inverted Yield Curve