Vanguard Intermediate-Term Corporate Bond ETF (NASDAQ:VCIT) focuses on intermediate-term investment grade corporate bonds in the United States. The ETF tracks the Bloomberg Barclays U.S. 5-10 Year Corporate Bond Index. The fund holds bonds with between 5 and 10 years until maturity. VCIT has very low credit risk as all of the bonds in its portfolio are investment grade bonds. However, this fund has slightly higher risk than U.S. treasuries as more than half of its bonds belong to the lowest level investment grade bonds. The fund has moderate interest rate risk due to the fact that its portfolio of bonds has an average duration to maturity of 7.4 years. The ETF offers a 3.4%-yielding dividend. Since we think the U.S. economy will re-accelerate in 2020, this will result in higher treasury yield and as a consequence, VCIT's fund price will likely trade lower. Therefore, we think it may be better to wait on the sidelines.
Data by YCharts
When evaluating bonds, we typically look at three things. First, we look at whether the bond is safe or not (credit risk). Second, we look at how well these bonds are impacted by the interest rate (interest rate risk). Third, we look at whether this is the time to buy these bonds or not. Here, we will go through this checklist one by one.
Low credit risk
VCIT only holds investment grade bonds. Therefore, credit risk is pretty low for VCIT's portfolio. We like VCIT's focus on investment grade bonds as investment grade bonds have much lower default rate than high yield bonds. In fact, investment grade bonds' default rate is only about 0.10% per year (based on 32-year period measured). On the other hand, default rate for below-investment-grade bonds is about 4.22% per year. Therefore, we believe VCIT's portfolio of bonds is mostly safe.
Source: Vanguard Website
Although credit risk is low for VCIT, investors should keep in mind that about 57% of the funds are Baa rated bonds (see chart above). Baa rated bonds are at the lower end of the investment-grade credit spectrum. Hence, in an economic recession, some of these borderline issuer's credit ratings may see their ratings downgraded to non-investment grade bonds. Therefore, VCIT is still riskier than the U.S. treasuries. Given VCIT's high exposure to lower quality investment grade bonds, its fund performance will most likely underperform other U.S. treasury ETFs in an economic downturn.
Moderate interest rate risk
Next, we look at VCIT's interest rate risk. VCIT's portfolio of bonds has an average effective maturity of 7.4 years. This is shorter than many long-term bond ETFs (10-20 years) but longer than short-term bond ETFs (less than 5 years). What does this intermediate average effective maturity mean to investors? Its intermediate maturity term means that the fund's performance is moderately sensitive to the change of interest rates. As can be seen from the chart below, VCIT's fund performance is still inversely correlated to the 10-year treasury rate.
Data by YCharts
Since VCIT has low credit risk, we think what is really important in investing in VCIT is to know which direction the treasury rate will move. Is it trending upward or downward? If an economic recession is coming very soon, treasury rates will move downward and vice versa.
In the near term, we believe the lingering trade uncertainties and talks may continue to weigh on the treasury rate. However, the better than expected Q3 2019 GDP number (1.9% growth rate) is a sign of the robust U.S. economy. With a record low unemployment rate, and happy consumers, we do not think a recession is coming. The Federal Reserve's action to lower its key interest rate is simply a preventative measure. In other words, the actions were to stabilize the confidence of the market. Once the economy growth rate re-accelerates (and inflation re-inflates), we think treasury rates will move up. This may not be good signs for investors of VCIT as higher treasury rates will push down VCIT's fund price.
High exposure to cyclical sectors
VCIT has a higher exposure to cyclical sectors such as finance and industrial sectors. Companies in these sectors will probably underperform in an economic downturn, and is prone to credit rating downgrades if their balance sheet deteriorates. This is one risk investors should keep in mind.
Source: Vanguard Website
VCIT investors will receive dividends with an annualized yield of about 3.4% on a trailing 12-month basis. This yield is generally higher than treasury funds with intermediate term average effective years to duration because it carries more lower-grade investment grade bonds. It is simply a trade-off between yield and credit quality.
Data by YCharts
Investors of VCIT will earn a 3.4%-yielding dividend. This fund is one to own in an economic uncertainty. However, if you believe the GDP growth rate will re-accelerate, which we still hold this view, we think you may want to wait on the sidelines. A pullback will provide a better risk and reward profile.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: This is not financial advice and that all financial investments carry risks. Investors are expected to seek financial advice from professionals before making any investment.