2023-04-25 05:08:06 ET
Summary
- Investors should avoid "chasing yield" - especially among funds with low coupon bonds where a large portion of the YTM is based on capital appreciation back to par.
- The 1-3 year fixed income space is beginning to look better on an individual security level, but not super appealing when looking at ETFs.
- As sub-1% coupons (and other lower coupons) roll off over the next year, VGSH will become more attractive on an income basis for investors seeking yield.
In late February we discussed the need for investors to pay attention to exactly where they were putting their cash to work so that they could maximize income while avoiding any losses (realized or unrealized). It is funny how sometimes real-life catches up to what we are writing about here on Seeking Alpha. We have had a few clients ask to discuss this very topic while also pondering opening up accounts that would be allocated as cash-specific investments. You have to go back like 30 years since that was a normal topic (outside of the institutional-level accounts) for investors.
One ETF that people seem to be interested in is the Vanguard Short-Term Treasury ETF ( VGSH ). From a fund perspective, this is an excellent tool for investors to use when allocating funds in their portfolios. Vanguard offerings have low expense ratios (this ETF has a 0.04% expense ratio) and are often able to attract large amounts of capital that ensure liquidity and that the fund performs correctly. The key here is that this tool must be used properly and understood by the investor - because the construction of the security, and how it functions, is important to understanding how it can generate positive returns from its underlying portfolio.
Income Generated
These fixed-income (and money-market) funds have two ways of generating income; capital gains and interest income (while ETFs have tax advantages, they do have years where they report taxable activity outside of interest). Sure, there are ways to generate revenues from other avenues such as securities lending, but managers really have just these two main levers to pull. As some people have approached us in discussions about the Vanguard Short-Term Treasury ETF, there has been confusion over the Yield-To-Maturity, or YTM, and the net indicated yield.
It is important to understand how the composition of a fixed-income portfolio will behave in various types of markets, especially when looking at YTM and average coupons. (Vanguard)
The portfolio composition/characteristics of the ETF, per Vanguard's website, highlights exactly what we are talking about. The yield-to-maturity is 4.1%, however the average coupon is only 2.1% - meaning that on average the bonds in the portfolio trade at significant discounts to par. Again, this is fine so long as one understands what they are getting into because the expected yield (based off of distributions) is 2.93%, and that is what most investors are actually concerned with right now.
VGSH has seen its distributions increase, however they have risen at a slower pace than funds focused on the shorter-end of the curve or floating rate instruments. (Vanguard)
While investors have seen the dividend distribution increase significantly over the last 10 months, they would have been better off owning a money-market mutual fund or floating rate fund over the same period. Without headwinds on the principal side and lower durations, those funds have seen interest income and distributions increase at a much faster pace with returns blowing away funds in the 1-3 year maturity space.
Capital Gains/Losses
While the capital gains and losses generally get washed on these types of ETFs, from time-to-time they do pass through. For instance, investors in the Vanguard Short-Term Treasury ETF had distributions of both short and long-term capital gains in 2013, 2014, 2015, 2016, 2020 and 2021. With the fact that the managers have many low-coupon, below-par trading bonds to choose from within their investable universe, we suspect that they will continue to gradually work the coupon higher while also continuing to purchase below par bonds out of necessity (you can read the prospectus here , but the managers are having to constantly rebalance the portfolio while maintaining certain thresholds within the holdings of the index as cash flows ebb and flow within the ETF itself).
If the yield curve starts to normalize, and the Fed slows or pivots, then we could see capital gains this year. If the Fed stays aggressive then expect the net indicated yield to continue to lag here and total return to be weighed down from lower bond prices.
Our Thoughts
Currently we are focused on utilizing cash to generate income and preserve capital. In short, it is the counterweight within the portfolios we manage that is used to offset the volatility in the market. The fact that cash can now yield 4%+ and provide total returns that best some dividend paying stocks has provided a nice boost to returns while simultaneously taking some risk off of the table. However, when buying fixed-income securities with maturities outside of one year, we find ourselves utilizing individual securities right now instead of the ETFs due to our ability to better manage returns and cash flows with these securities in our portfolio rather than one within an ETF. While you do have to have some size to make the work worthwhile, we have found that avoiding taking losses (or recognizing opportunity costs, like giving up the majority of your expected YTM by selling before maturity) is beneficial to us. Individually owned securities can roll down past the 12 or 13-month mark (where many of these funds must look at exiting positions as they fall out of the benchmark/index), thus ensuring that the YTM that we purchase at is realized if we continue to hold the security, and does not give us a misleading yield assumption like the ETFs do from time-to-time.
If investors are purchasing this ETF now and banking on the returns being similar to the YTM, we would recommend looking elsewhere for those capital gains in the fixed income world. A closed-end fund would be a much better tool for achieving capital gains as your gains will not be diluted because of fresh fund flows. If investors are looking for income with their short-term cash, then we would recommend money-market funds or even some floating-rate ETFs. The key for short-term cash is a NAV that stays relatively stable and a distribution yield close to the current market rate.
With the yield curve currently inverted, this particular fund tracking the Bloomberg US Treasury 1-3 Year Bond Index and the U.S. Federal Reserve having raised rates dramatically over the last 12 months, we think that the net indicated yield could lag on the Vanguard Short-Term Treasury ETF. Eventually the portfolio will reset, with coupons being closer to market rates, or the Fed will pivot which will help asset prices within the portfolio, but until that happens we are not rushing to buy full allocations of funds such as the Vanguard Short-Term Treasury ETF. We like everything about it except the current structure in this particular market and how we see gains playing out once the Fed does pivot.
The good news? Once the market does return to a normalized rate environment with a normal interest rate curve, this will be a solid pick for investors' allocation to the 1-3 Year Treasury portion for their fixed-income portfolios. Until then, we continue to believe investors are better off utilizing money-market funds or even short T-bills, especially with 90-day T-bills having crossed above 5%. If you already own this name and the invested funds are not part of your short-term cash allocation, then holding this as a small allocation within your portfolio for the time being is fine.
For further details see:
VGSH: Value Your Cash, Understand Risk