2023-08-03 14:32:51 ET
Summary
- Vanguard Total Bond Market Index Fund ETF has faced challenges due to rapid rate hikes by the Federal Reserve.
- BND is well-diversified with 10,543 individual bonds and a majority of its holdings in US treasuries.
- While BND's yield is lower than other less risky assets, it offers potential for capital appreciation when rates eventually decline.
Vanguard Total Bond Market Index Fund ETF (NASDAQ: BND ) has faced challenges in the past couple of years due to the Federal Reserve's rapid rate hikes. The Fed has raised rates extremely fast in an attempt to get inflation under control and they are currently the highest they have been since 2001. This, of course, caused the price of bonds to fall. While BND's 30-day SEC yield of 4.43% isn't as impressive as many other bond funds, specifically short-term bond funds, I think there is a lot of money to be made from capital appreciation longer term. I rate BND a Buy.
Holdings
BND aims to replicate the investment results of the entire US investment-grade bond market, excluding inflation-protected and tax-exempt bonds. It holds 10,543 individual bonds. BND's top 10 holdings make up only 5% of the ETF, making it extremely well diversified in my view.
BND's top 10 holdings (ETF.com)
67% of BND's AUM is in US treasuries, with the remaining third in US corporates. The largest holdings of corporates are BBB bonds, with A-rated bonds closely behind.
BND's holdings by credit rating (Vanguard.com)
BND's average effective maturity is 9 years. Its largest holding is 1-5 year bonds, making up 40% of the ETF.
BND's holdings by maturity (Vanguard.com)
Yield
The Fed funds rate has gone up extremely fast in the past few years. It's currently the highest it's been since 2001.
This caused bond prices to fall, driving yields up. Currently, BND has a 30-day SEC yield of 4.43%. This is much higher than it has been over the last decade because the Fed funds rate was practically zero for the majority of the time. While BND's yield has gone up, it's still lower than many other far less risky assets, mainly t-bills. SGOV , a 1-3 month t-bill ETF, has a 30-day SEC yield of 5.31%, almost an entire percent higher than BND. If this is the case, why would anyone want to own BND when you can get a higher yield with far less risk?
Capital appreciation
The answer is capital appreciation. When the Fed inevitably cuts rates, or even before then as the economy begins to slow appreciably, BND should appreciate while its yield goes down. Unlike BND, t-bills and t-bill ETFs like SGOV experience almost no capital appreciation while their yield goes down. The yield of short-term bond funds will also decline more rapidly than BND's because of BND's longer maturities.
Many investors are looking to benefit from a high current yield, but also from capital appreciation in the future. Every bond investor knows that when rates go down, bond prices go up. In theory, it's simple to profit from capital appreciation; buy BND just before rates begin to fall. However, it's very hard to time the market and the Fed. If this is the case, why should you buy BND now?
Why now?
Now might not be the perfect time to buy, but it's definitely a good and reasonable time. In the last FOMC meeting, Fed Chairman Powell announced that the Fed would take it meeting by meeting when considering whether or not they should raise rates again. Before this, we were told to expect 2 more rate hikes, one of which happened this month, and then one that is no longer officially forecasted by the Fed. Taking it meeting by meeting suggests that there isn't really a timeline for if/when we should expect more rate hikes. We can infer that the Fed no longer thinks inflation is out of control if they aren't preparing investors for many more hikes. Instead, they are simply leaving more rate hikes as a possibility. This is the foundation of my thesis. These historically fast rate hikes are coming to an end.
Past performance
The price of BND has dropped drastically in the past few years. The chart below shows the fed funds rate and the price of BND over the past 10 years.
I normally don't highlight past performance in my articles, but I think it's valuable in this instance because it shows how much room there is for capital appreciation. Rates shot up and BND's price fell fast. Rates have a lot of room to go down, and BND has a lot of room to go up. I certainly don't expect rates will go back to near zero within the next few years, but because of how high rates were raised, even modest rate cuts should provide a good amount of capital appreciation in my view.
The waiting game
I think buying BND right now is best for passive investors. It's not certain if rates will be raised again, and we don't know when rates will begin to be cut. Investors who buy BND will have to wait until the Fed begins to cut rates and/or a slowing economy drives down longer-term rates before they can benefit from capital appreciation. While they wait, they will receive a reasonably high yield.
The active approach
While I believe it's extremely hard to predict the future course of interest rates, I know many other investors prefer to try to time the market and the Fed rather than take a passive approach. I have a strategy to suggest for this, too. Own an Ultra-short-term treasury bond ETF now (I suggest SGOV) then when you believe rates have peaked, switch to BND. This allows you to get a higher yield with little risk now, and then add some risk for capital appreciation in the future. Obviously, this strategy has the added risk of market timing.
Why BND for capital appreciation
There are plenty of bond ETFs that will experience capital appreciation, so why is BND the best choice? BND's average effective maturity is 9 years, which is intermediate term. This means that it isn't a higher-risk investment like long-term bonds and that it also has capital appreciation potential, unlike short-term bonds. It's in a sweet spot. It's the best option for passive investors because it holds bonds with all different maturities. BND is balanced. The short-term bonds BND holds give investors a low risk and high yield while the longer-term bonds give it capital appreciation potential.
Risks
As described above, a third of this ETF is in corporate bonds. I, as well as many others, believe the US economy is headed into a mild recession. The key word is mild. If the recession is mild, corporate default rates will likely rise, but not by much for investment-grade bonds. If this recession is severe, corporate default rates will go up, hurting BND. However, the US economy has shown resiliency despite high interest rates. Inflation is slowly but surely coming down while the economy stays healthy. I doubt that we will enter a severe recession.
Another potential risk is that if rates continue to go up, BND will depreciate. The capital appreciation factor discussed above works both ways. If rates continue to rise, BND will depreciate. I think this is very unlikely to have a major effect. There may be one more rate hike in 2023, but the odds of there being so many rate hikes in 2023 to the point where it severely hurts BND is very low.
Conclusion
Now is a very reasonable time to buy BND in my view. While it's possible there may be another rate hike in 2023, I suggest buying now rather than trying to guess what the Fed and market will do next. It may be a year or two before rates begin to fall, but while investors wait, they will receive a nice dividend yield of about 4.4%. I rate BND a Buy.
For further details see:
BND: It's Finally Time To Buy