2023-07-06 14:18:06 ET
Summary
- Vanguard Short-Term Treasury Index Fund ETF Shares invest in short-term fixed-income U.S. Treasury bonds with maturities of 1 to 3 years.
- Government bond yields climbed in the second quarter of the year, with investors predicting further increases due to persistent signs of economic strength.
- VGSH stands to benefit from the persistence of the yield inversion curve along with the consistent outperformance of 2-year Treasury yields over 10-year Treasury yields.
Launched in 2009 with a total AUM of over $22 billion, Vanguard Short-Term Treasury Index Fund ETF Shares (VGSH) invests in short term fixed income U.S. Treasury bonds with maturities of 1 to 3 years. The fund does not invest in TIPS or Treasury Inflation Protected Securities. VGSH seeks to track the performance of the Bloomberg U.S. Treasury 1-3 Year Index using a representative sampling technique, and it selects and weights its holdings using a market value weighting methodology. Overall, interest rate exposure will be relatively lower as the fund is able to mitigate both credit and interest rate risk.
This strategy may be especially favorable considering the current conditions of the economy. These shorter term bonds have held well and will continue to perform during times of aggressive interest rate hikes. They are inherently less risky with the highest investment grade bonds, and its relatively equal exposure may further assist in mitigating risk, especially concentration risk.
Holdings
VGSH invests in a total of 96 US Treasury bonds with a yield to maturity rate of 4.5% and an average maturity and duration of 2 years. While investors may view a large focus on short term bonds as especially risky, the fund effectively mitigates most of its concentration risk by having a relatively lower percentage, 18%, in its top 10 holdings.
As mentioned earlier, VGSH invests exclusively in short-term bonds, with over 50% in 1-2 year maturities and the remaining in 2-3 year maturities. Since the fund invests in US Treasury securities, all bonds will be of the highest investment grade of AAA.
Treasury Yields Continue To Climb
US Treasury bonds may be becoming more attractive for those interested in income bonds. This is primarily because of recent increase in treasury yield in the past few months. Government bond yields increased dramatically in the 2nd quarter of 2023 following the banking crisis in March. This is mostly attributed to more favorable economic conditions and a relatively stable banking sector following the crash. Large banks seem to be benefiting from the crash, and this could likely propel growth in government bond yields for months to come. Moreover, US Treasury bonds have experienced a large influx of bond buying as a result of fear in the potential banking crisis as bonds were seen as a safer among investors. Confidence in the banking sector has transferred to Treasury bonds, and this has resulted in higher yields. Lower inflation and higher interest rates have also increased confidence in Treasury bonds.
In fact, US Treasury 2 yield bonds have experienced a larger surge than treasury 10-year bonds. Short-term bonds have benefited from this especially, which is what VGSH invests in entirely. 2-year Treasury yields have experienced a sharper increase recently as investors anticipated several Fed interest rate hikes in 2023 and these bonds are much more sensitive to Fed hikes than 10-year yield bonds.
2-year yield bonds have also consistently outperformed 10-year bonds in the past year. This is especially surprising considering that yields typically increase with longer Treasury bonds, but there has recently been a reversal of the yield curve . As seen in the graphs below, as of June 2023, shorter term bonds have experienced a higher yield than long term bonds. This is wildly different from the yield curve at the onset of 2022 where yields grew as bonds maturities increased.
Interest Rate Risk
I believe that right now is the time to own short term US Treasury bonds as they have less interest rate risk than long term Treasury bonds. Primarily, choosing between short term and long term bonds depends entirely on what you think will happen with interest rates. If rates were to decline, then long term bonds would be the move. However, I anticipate a few more hikes in 2023 and into 2024, so short term bonds are more attractive to me. A majority of VGSH's holdings are bonds with securities of 2 years, and investors find these bonds especially attractive as they are easier to hold until maturity. Interest rates and bond prices are inversely related, and investors can experience losses on their long term Treasury bonds when interest rates rise. Alternatively, short term bonds allow investors to quickly reinvest at a higher interest rate if rates continue to rise in the near term. Then, it might be beneficial to reinvest in longer term bonds and lock into that higher interest rate. Additionally, 2-year Treasury bonds are more sensitive to policy changes by the Federal Reserve. They react more quickly to changes in the interest rate, and the fact that 2-year yields have consistently outperformed 10-year yields in the past 12 months also are warning signs of an incoming recession. This is the time for short term Treasury bonds to shine when investors are favoring safer assets over riskier corporate bonds.
Bottom Line
Overall, I think that now is the time to own short-term Treasury bonds. Short term bonds are inherently less risky than long term bonds, and Treasury bonds are especially safe during periods of recessionary concerns. The inverted yield curve has persisted for the past 12 months. Since World War II, every economic recession was preceded by a yield curve inversion. This means that investors are losing confidence in the economy along with riskier investment opportunities. Investors should capitalize on this consistent inversion of the yield curve and invest in short term Treasury bonds as their yields have consistently outperformed longer term bonds in the past year. With that being said, I rate VGSH a Buy.
For further details see:
VGSH: Now Is The Time To Own Short-Term Treasury Bonds