2023-09-29 08:08:53 ET
Summary
- Schwab U.S. Aggregate Bond ETF has had a flat return over the past year, underperforming other investment options.
- Rising yields on treasuries have been the main reason for SCHZ's underperformance.
- Despite the risks, treasuries remain in demand, which could limit downside risk and potentially drive gains in the future.
Main Thesis & Background
The purpose of this article is to evaluate the Schwab U.S. Aggregate Bond ETF (SCHZ) as an investment option at its current market price. This is an ETF with a primary objective "to track the total return of an index that measures the performance of the broad U.S. investment-grade bond market".
Generally speaking, I have been cautious on bonds over the past few years. As my followers know, I have suggested exposure to munis and high yield floaters, but IG-rated corporate credit has lacked some value for a while (in my view). To illustrate this point, consider that exactly a year ago I reviewed SCHZ and placed a "hold" rating on it. Over time, this was about as spot-on as one can be:
Fund Performance (Seeking Alpha)
Given the time that has passed I thought an updated review was due. Unfortunately for the bulls, there is still not a lot to love about aggregate bond funds. With inflation and Fed rates remaining elevated, bonds have a shaky future ahead. Of course, if inflation resumes a decline and the funds rate has "peaked", then there is reasonable upside ahead for SCHZ. But the risks posed by the macro-environment suggests some merit for caution in my mind. This adds up to a consistent "hold" outlook going forward.
Why The Flat Return? Yields Kept On Rising
To start, let us take a look at how we got here. Of course, SCHZ has not "lost" money in the traditional sense over the past year. But with a flat return, that is not very good, considering investors would have been better just about anywhere else - including cash!
So - why has SCHZ been such an under-performer? The crux of it lies with the holdings. The positive is this fund is well diversified between treasuries, MBS, and IG-rated corporate bonds. But treasuries still make up the bulk of the underlying exposure:
SCHZ's Portfolio (Charles Schwab)
This should be clear, then, to readers why SCHZ has struggled. Treasuries have not been a very attractive sector in the past year. This is because yields have risen consistently as the Fed has raised its benchmark rate consistently.(When yields rise, prices of current bond issues fall). While there have been temporary reprieves on this front, they have been short-lived:
10-Year Treasury Curve (S&P Global)
The point here is that rising yields are going to pressure treasuries and lower treasury prices will extend to pressuring SCHZ. This has been the case since last September and in the immediate term there is not a lot to suggest this will change. Inflation remains high (albeit lower than it has been) and the Fed has reiterated more hikes may be on the way:
We want to see convincing evidence really that we have reached the appropriate level, and we're seeing progress and we welcome that. But, you know, we need to see more progress before we'll be willing to reach that conclusion "
Source: C-SPAN
The takeaway is the Fed may be done - or it may not. This makes the outlook for aggregate bond funds like SCHZ uncertain. Is there a path higher? Absolutely - especially if the Fed is done with its hiking plans. But there is more downside if the Fed keeps going, and it has signaled it might. This reality is why a neutral/hold rating makes sense. There is no certain path forward and that makes being either a bull or a bear difficult at the moment.
How Could Treasuries Rise?
I touched on a few risks above but the overall backdrop is not overly bleak. So this isn't meant to be alarmist or overly bearish. Remember my rating remains "hold" going forward - so that means there have to be some positive aspects to consider.
One of those bright spots is that treasuries remain in demand - especially by foreign investors. Despite how poorly treasuries have performed, there have been buyers outside US borders coinciding with this performance:
Foreign Holdings of US Treasuries (Bloomberg)
This should limit the downside risk going forward and is central to why I am not a bear on SCHZ. In the right environment, this treasury exposure could drive gains in the months ahead because I am fairly confident these buyers are not going to suddenly drive up. If that road out the past twelve months, I don't envision them fleeing for the exits now that inflation has finally started to cool in a meaningful way:
CPI (Bureau of Labor Statistics)
The conclusion to draw here is that inflation is trending in the right direction and if that continues then bonds and treasuries could rally. I touched on why this is not a sure thing in the prior paragraph, but I had to give some space in this review to the other side of the coin. Treasuries have seen robust demand and have a potential catalyst with respect to inflation metrics. Readers should weigh this carefully before deciding whether to buy or sell SCHZ.
Aggregate Funds Perform Well When Equities Tank
Beyond just the forward outlook for treasuries in isolation, there are other factors to consider. One is fundamental to why investors buy bonds in the first place. Part of it is for income, sure, but IG-rated bonds don't generally deliver enough income to live on. The other part of their attractiveness is the correlation with equities. IG-rated bonds and treasuries generally have a weak or negative correlation with large-cap stocks. This makes them ideal for investors who are anticipating a broad market sell-off.
With the uptick in volatility over the past two weeks, this may be piquing the interest of many Seeking Alpha readers out there. To see why, let us consider how the aggregate bond index has performed during past periods of market stress:
Market Performance During Turmoil (Pink is Agg Index, Green is S&P 500) (BlackRock)
What one could draw from this is that if equity markets are about to get hit, then funds like SCHZ are a pretty solid play. Personally, I think the uptick in volatility in the equity markets represent a buying opportunity - so I won't be selling my positions in favor of aggregate bond funds. But others may disagree and, if so, then the above graphic illustrates why SCHZ should be on the radar if equity losses are expected.
Yields Just Aren't Enticing Enough
To wrap up this review, I want to talk about the income stream. Through this review it should be clear that I don't expect a big move in SCHZ in either direction - up or down. But one could then consider that if the move is going to be flat, at least they are getting the yield. With a SEC yield over 4.5%, this isn't a bad proposition, right?
SCHZ's Current Yield (Charles Schwab)
This is where I beg to differ a bit. In the sense that I just don't see a lot of value at these levels. If one wants to earn income, they are going to have to go beyond treasuries and corporate bonds that are offering yields on par with savings accounts:
As you can see, aggregate bond funds and IG-rated corporates and treasuries are near or below the 5% mark. To earn more, one has to branch in to high (junk) bonds or non-US debt. This is something to consider, but it may not be for everyone, as there are unique risks to consider.
For me, this helps to justify why I don't really feel the need to own SCHZ. The current yields in the underlying sectors aren't strong enough to justify the potential downside risk. Yes, one could earn more if bonds rise, but the opposite is also true. By contrast, many savings accounts and CD's are offering similar income streams. This means one could own this income exposure without any downside risk:
Examples of Current Savings Rates (Nerd Wallet)
Until this backdrop changes, it will be difficult for me to come up with a strong buy case for a fund like SCHZ. This realistic approach is why I am reluctant to upgrade my outlook for now.
Bottom-Line
SCHZ continues to deliver non-existent returns and the stage is set for that to continue in the short-term. Over time, once the Fed backs off its hiking path and inflation normalizes, then upside will be realistic in this fund - and others like it. But for now I can't get excited for a 4.5% yield with downside potential when there are ways to earn 5% with no downside risk. Therefore, I am maintaining my "hold" rating on SCHZ and would advise my followers to approach any positions very carefully at this time.
For further details see:
SCHZ: Not A Lot Of Value To Be Had