VTC - VUSB: A Trifecta Of High Yield Low Risk And Capital Appreciation Potential

2023-07-15 05:19:40 ET

Summary

• The Vanguard Ultra-Short Bond ETF is a Buy because of its low volatility, high yield, and potential for capital appreciation amidst market uncertainty.
• VUSB holds short-term high-quality bonds and has a 30-day SEC yield of about 5.45%.
• VUSB may be a better choice for investors than many of its peers because it's in a risk-return sweet spot.

As we draw closer to the pending recession, I've been searching for assets that can provide low volatility, a high yield, and some potential for capital appreciation. Vanguard Ultra-Short Bond ETF (VUSB) meets all three of these requirements. VUSB is a relatively small ETF, with AUM of about $3.5B. It also has an impressive 30-day SEC yield of about 5.45%. VUSB is actively managed but still has a low expense ratio of only 0.10%. Because VUSB offers investors low volatility, a high yield, and some potential for capital appreciation during this period of market uncertainty, I rate VUSB a Buy.

Holdings

VUSB has 642 holdings, offering exposure to money market instruments and short-term high-quality bonds, including asset-backed, government, and investment-grade corporate bonds. VUSB is actively managed and these holdings are subject to change, but currently, VUSB's top 10 holdings make up about 18.5% of its AUM, making this a well-diversified ETF.

Only about 11% of VUSB is in treasuries. Most of its holdings are in corporate bonds and about 56% in bonds issued by financial companies.

Due to its high concentration of corporate bonds, VUSB carries higher risk and, consequently, offers a higher yield. VUSB limits some risk by holding higher-quality investment-grade bonds.

Over 60% of the ETF is in A-rated bonds or better. Finally, 61% of the bonds VUSB holds have a maturity time of under one year, and over 90% have a maturity time of under two years.

Low Volatility

VUSB's volatility is low because it holds short-term treasuries and highly rated corporates. SGOV (iShares 0-3 Month Treasury Bond ETF) is an ultra-low volatility asset. The chart below shows VUSB's and SGOV's total return over the past year.

VUSB is clearly more volatile, but not by that much. This chart showcases that while VUSB isn't an ultra-low volatility asset like SGOV, it still has low volatility, and as I will discuss later, this added volatility can be a strength. Let's now compare VUSB to a moderate volatility asset. When you compare it to BND (Vanguard Total Bond Market Index Fund ETF) you can really see how little volatility VUSB has. The following chart shows the total return of VUSB and BND over the past year.

As the image above shows, BND has been bouncing between -8% and 0% while VUSB has been on a relatively stable upward trend.

High Yield

Interest rates are currently at a two-decade high, and because of the inverted yield curve, short-term bonds, like the ones VUSB holds, have a higher yield than longer-term bonds. This causes VUSB to have low volatility as well as a high yield. VUSB boasts an impressive 30-day SEC yield of about 5.45%. This yield is higher than that of SGOV's, BND's, and VTC 's (Vanguard Total Corporate Bond ETF).

VUSB has lower volatility than BND and VTC and a higher yield, and while SGOV only has a slightly lower yield, it lacks the capital appreciation aspect that VUSB has.

Capital Appreciation

Every bond investor knows that when rates go down, bond prices go up. Fed Chairman Powell has told investors to expect two more rate hikes in 2023. The image below shows the CPI since 2020.

The CPI is clearly coming down, and the June inflation report came in lower than expected. Inflation coming down faster than expected means that it's likely that Powell's forecast of two more rate hikes is accurate. If inflation continues to slow faster than expected, it's even possible for there to be only one. Once inflation is under control and the economy slows sufficiently, the Fed will cut rates. The Fed has advised us that this will likely not happen for a couple of years. This is where VUSB can become even more valuable. VUSB can offer low risk and high yield while investors wait for these rate cuts, and once the cuts happen, VUSB will appreciate.

VUSB is in a risk-return sweet spot for me. It's riskier than SGOV but offers much more capital appreciation because it holds longer-term bonds as well as corporate bonds. It's less risky than BND and VTC and also currently has a much higher yield. While VUSB won't appreciate as much as these two ETFs when rates fall, the low risk and high current yield make it worth it in my opinion.

Risks

VUSB's capital appreciation aspect works both ways, if rates rise dramatically, VUSB will depreciate. However, based on the information we have been given by the Fed and the June inflation report, it seems very unlikely that there will be more than two additional rate hikes. I don't think this is something to worry about right now.

Conclusion

VUSB is a low-risk ETF with a yield that is higher than many of its peers. VUSB also offers potential capital appreciation. While there are some other ETFs that have more potential for capital appreciation, I think the higher current yield and lower risk that VUSB offers makes it a better choice. I rate VUSB a Buy.

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