Vanguard Long-Term Corporate Bond ETF: add to your portfolio

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Kameleon007

The Vanguard Long-Term Corporate Bond Index ETF (NASDAQ: VCLT) is a useful fixed-income investment vehicle for simultaneously investing in debt issued by many companies. I became interested in this ETF after noticing that it had produced a rise of 3.41% during last month as shown in the blue chart below, which is abnormally high for bonds given the current high interest rate environment.

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VCLT data by YCharts

The reason for the gain, shown by the upbeat S&P 500 price performance of over 13%, appears to be that US inflation slowed more than expected in July, implying that the Federal Reserve may reduce the aggressive pace at which it is raising interest rates.

Thus, my goal with this thesis is to assess whether there can be a sustained upside in the Vanguard ETF, but, first for those new to the bond world, I provide a quick overview of the reasons for which long-term investment grade bonds make sense at this point.

Investment grade bonds

A business in need of fresh cash can issue a bond that can then be used to fund its operations, pay capital expenditures, acquire another business, or even pay off older, more expensive debt. Issuing bonds is therefore an alternative to bank financing which can in certain circumstances be more expensive and also represents a viable alternative to issuing new shares which dilutes the capital of companies.

Moreover, individuals who have tried to invest in bonds issued by individual companies are already familiar with the constraints such as having to make minimum investments of $2,000 or more. So, unless you are an institutional investor with hundreds of thousands of dollars to invest, VCLT makes your life easier because you can buy any amount of its stock on the stock exchange, just like a stock. It also helps diversify your bond portfolio as it holds the debt securities of many companies as shown in the table below. Moreover, according to Vanguard, it is mainly high quality corporate bonds (investment grade).

Avant-garde

Top VCLT Holdings (investor.vanguard.com/)

Looking deeper into the table above, one can see the maturity dates extending anytime from 2036 to 2055, which means that these are long duration bonds, namely with a maturity (dollar-weighted average) of 10 to 25 years.

Another finding is the coupon rate, which varies from 3.5% to 5.8%. The average coupon rate is 4.5%, which is higher than the Vanguard Short-Term Corporate Bond Index ETF (VCSH) of 3.1%. The reason for this is duration, with short-term bonds with an average maturity of three years being the safest as they are commonly used by companies to fund a cash need. In contrast, longer-term bonds with a maturity of more than 10 years are generally issued by companies to finance development or acquisition projects. Therefore, they offer higher interest rates because they tie up lenders’ money for much longer, in this case over a decade.

The risks

This involves more risk for those investing in long-term corporate bonds as they are more likely to experience multiple economic cycles, as well as associated market turbulence. One such example came in March 2020 when lockdowns by governments around the world after the World Health Organization declared COVID a pandemic led to economic uncertainty as investors began to pull their money out of stocks. As a result, the S&P 500 lost over 30%, as shown in the chart below. However, even investment-grade bonds held by VCLT suffered, as seen in the middle chart, but the loss was less severe than the broader stock market and the ETF also recovered faster.

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SPY data by YCharts

Furthermore, the chart above shows that even VCSH, despite holding short-term bonds, also saw considerable outflows.

Therefore, during periods of high market volatility, corporate bonds, whether long-term or short-term, are likely to suffer. That said, investment-grade corporate bonds should recover faster, not only relative to the S&P 500, but also relative to other forms of debt investment tools, such as high-yield bonds. An example of high yield corporate bonds is the Vanguard High-Yield Corporate Fund (VWEHX) which offers an average coupon rate of 4.8%.

However, with this higher return comes more risk, which brings me to the level of risk associated with bonds.

In this regard, investment-grade bonds are issued by companies whose risk of default or non-payment of interest on borrowed money is considered to be virtually zero (zero) in the future, as evidenced by companies like Bank of America (BAC), Apple (AAPL), or even Boeing (BA), according to the table above. As such, they are rated at least Baa3 by Moody’s, a rating agency. For investors, obligations rated Aaa are considered to have minimal or highest quality credit risk, while Baa3 are subject to moderate credit risk. These are better rated than the bonds held by VWEHX.

Balancing risk and returns

Therefore, balancing the risks with the average coupon rate, VCLT is a better investment than VCSH or VWEHX. I’ve also included a comparison to the Vanguard Extended Duration Treasury ETF (EDV) per the chart below, for those seeking comfort in treasury bills or government-issued bonds. These are considered safer than private companies, and Moody’s rates long-term US government issues as Aaa, or investment grade.

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Comparison with short term corporate bonds, high yield and treasuries (www.seekingalpha.com)

Looking at price action, the chart above indicates that with a one-month performance of 0.39% being the weakest, Treasuries are not enjoying the same level of investor enthusiasm. than corporate bonds. This is explained by the fact that while the macroeconomic environment remains uncertain, things are not going so badly. Thus, the number of unemployed fell to 3.5% in July, the lowest since February 2020, while inflation also seems to have peaked as I mentioned above.

Under these conditions, investors are turning to equities, with some analysts now expecting to see the S&P 500 at 4,800 after a 14% rise. However, inflation remains high and there is also talk of a recession in 2023.

In these circumstances, VCLT represents a more balanced approach, between high-yield bonds also called “junk bonds” and treasury bills to put idle money in the savings account at work. Additionally, while corporate bonds are considered less safe than government bonds, under current market conditions there is less likelihood that companies will default, especially those with investment grade ratings. superior. In this regard, the VCLT’s performance over one month of 3.92% confirms the fact that the market sees it as a more rational investment.

Conclusion

Finally, with the Federal Reserve continuing to tighten monetary policy to fight inflation, interest rates are expected to remain high through the end of this year, implying that bond yields will not fall. So, since the bond’s yield and value are inversely related, don’t expect VCLT to go up anytime soon. Instead, at less than $85 after its -20% year-on-year underperformance, use it as an income-generating investment vehicle in your portfolio.

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