- VGSH invests in one of the safest and most conservative segments of the market with a portfolio of 'AAA' rated short-term Treasuries.
- The ongoing blowout of corporate credit spreads highlights the value of Treasuries in a market stress situation as is currently being observed.
- VGSH is a good option for investors seeking capital preservation and to limit portfolio risks given its low-duration profile with a modest monthly income component.
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The Vanguard Short-Term Treasury ETF (NYSE:NASDAQ:VGSH) represents one of the more conservative segments of the market and a real sleep-well-at-night 'SWAN' type of investment. As risk-assets like stocks experience historic levels of volatility with serious concerns over the global economic outlook, investors should warm-up to the idea of capital preservation and low-risk fixed-income. We like VGSH as the short-term maturity and low-duration profile provides refugee in the current market environment. We think an allocation to VGSH can help reduce overall portfolio risk through diversification while still presenting a modest monthly income component with a current yield of 2%. The expense ratio of just 0.05%, VGSH a good low-cost bond fund to ride out market uncertainty.
VGSH Portfolio Background
There is nothing particularly exciting about short-term treasuries, but that's the point. Investors trading stocks higher during one of the greatest bull markets in history over the past decade could easily be forgiven for overlooking this traditionally very important market segment that is meant to be low risk beyond any yield or appreciation attributes. VGHS is invested in U.S. Treasuries with a maturity between 1 and 3 years.
(source: Vanguard/ image composite by author)
Low-Duration Represents Lower-Risk
VGSH's current average duration of 1.9 years implies a low level of interest rate risk which we feel is particularly important in the current market environment. Duration is a measure of the bond or bond fund's sensitivity to changes in the yield curve. The lower the duration, the less exposed the fund is to volatility in market rates with the risk being that rates rise and the value of the bond portfolio declines. For every point in duration, a bond is expected to lose that corresponding amount in percentage points for every 100-basis point increase in market rates. The opposite is also true in that a bond can appreciate by its duration amount should rates decline by 100 basis points.
Recognizing that rates have collapsed lower in recent weeks, long-dated bonds with high duration have outperformed significantly given increasing concerns over the global economic outlook which represents deflationary pressures and lower inflation expectations. The FED announced a historic emergency 50 basis point rate cut the funds rate last week in an effort to support market liquidity and stabilize sentiment. Indeed, the 2-year Treasury rate is now at 0.49%, down from 1.5% at the start of 2020. Similarly, the 10-year rate has declined to 0.74% from levels that approached 2% as recently as last December.
We contrast VGSH with Vanguard's Long-Term Treasury Bond ETF (VCLT), with an effective duration of 18.0, which is up by a massive 29.3% year to date compared to just 2.47% for VGSH. Still, any positive return at this point looks a lot more compelling compared to the 13% decline in the S&P 500 (SPY).
The point we want to emphasize is that even with the FED expected to cut rates again this year and the current economic scenario deeply bearish for risk-assets, it's not a sure thing that long-term rates can continue to trend lower and long-term bonds appreciate from here. Long-term bonds as well as stocks have greater uncertainty and represent a higher risk.
Remember that the FED only has control of the very short end of the yield curve while long-term rates are set by the market. One dynamic we're watching is that even with further rate cuts of the overnight Federal Funds rate, long-term bonds could still sell-off from current levels potentially from repercussions of aggressively dovish monetary policy.
While not our base-case, in a scenario where the coronavirus outbreak is contained faster than expected and global growth expectations recover, long-term rates can also begin to trend higher. Even a 25-basis point bounce in the 10-year Treasury rate from here through either mean-reversion or repricing at the long end of the curve would result in a nearly 5% loss for the Vanguard Long-Term Treasury ETF. While long-term bonds have "worked" thus far, investors are increasingly exposed to the potential for large downside swings. VGSH in this regard is protected against these risks.
'AAA' Credit Profile
The other benefit of short-term treasuries is its effectively 'risk-free' credit profile as the U.S. government is recognized as not facing the possibility of default. Typically, in normal market conditions, investment-grade corporate bonds can offer a yield advantage and higher appreciation potential compared to Treasuries given a credit risk spread. Essentially, for every point on the Treasury yield curve, a corresponding corporate bond should have a higher yield to maturity.
The problem here is evident in the chart below that tracks U.S. investment-grade 'BBB' rated or higher corporate credit spread to U.S. Treasuries. In the last financial crisis between 2008 and 2009, the spread surged to as high as 8% compared to levels under 2% for much of the past decade. What is being observed right now are the early stages of what could potentially be "credit blowout" with a widening spread in corporate bond yields to Treasuries. In a scenario where the current market outlook deteriorates into a recessionary environment, the credit spreads could accelerate a climb from current levels leading to corporate credit underperforming Treasuries. The best way to visualize this dynamic is that a comparable short-term corporate bond with an effective duration matching VGSH will see its value fall not because interest rates rise, but because the credit spread widens.
We highlight the Vanguard Short-Term Corporate Bond Index ETF (VCSH) which has a similar effective duration at 2.6 years, compared to 1.9 years for VGSH. Based on the credit spread dynamic, the short-term corporate bond ETF is down 0.56% over the past 5-days while the Treasury fund has gained 0.65% over the same period. The dynamic is even worse for "high-yield" or junk-bond segments. Treasuries are simply the only real type of safe have in the extremely volatile and bearish market environment as we find ourselves in today. For investors concerned about capital preservation, every basis-point counts.
The current yield on VGSH is stated at 2.18%. The expectation is that since the FED continues to cut rates, this yield level will trend lower going forward as the underlying interest income is reduced based on declining yields to maturity. A portion of the bond fund during any given month will mature and need to be reinvested at lower prevailing market rates. The last distribution of $0.0972 per share compares to $0.1218 in August of 2019 as rates have trended lower over the past year.
We think that this process has a lag over many months given the composition of the portfolio. By this measure, even if rates get cut to zero, VGSH should still present a positive yield through the remainder of 2020 in current market conditions. Beyond that, should rates turn negative, the fund can gain through the appreciation of the portfolio supporting its total return potential.
Analysis and Forward-Looking Commentary
We expect the ongoing coronavirus epidemic plaguing various countries and gripping financial markets to persist for the foreseeable future. COVID-19 is currently affecting 111 countries and territories as of March 9th, 2020 with over 110,000 cases and 3,900 deaths since the outbreak began earlier this year. While China was particularly hard-hit in the early stages, the chart we are looking at is the number of new cases outside of China which continues to accelerate higher suggesting the spread of the virus is continuing with some countries experiencing worse outbreaks than others. An outbreak pocket in any particular country poses risks to the global economic outlook until a vaccine can be developed.
While the extent of the public health crisis and financial impact is unknown, we see risks tilted to the downside for global growth expectations that should impact corporate earnings and represent further pressures on stock prices. As the negative repercussions spread to the economy and financial market, the risk of a recession has only increased which would be bearish for credit.
The irony here is that should the conditions improve faster than expected, this scenario would pose the greatest risk for long-term bonds if yields bounce from here and force a reversal of the recent moves in the flight-to-safety trends. In this "reflation" scenario, the short-term bonds and VGSH should outperform the long end of the yield curve.
We have been recommending investors add exposure to fixed income as a defensive position in the current market environment to limit portfolio risk. The Vanguard Short-Term Treasury ETF with its short-duration profile now also represents a cautious view on long-dated bonds that face increasing levels of volatility with interest rates at record low levels. Compared to "ultra-short" and cash alternative funds with even lower duration, we think VGSH is a good balance between risk and total return profile in the current interest rate environment. The end goal here is to limit risk and potentially maintain a level of positive yield while rates at the short end of the curve continue to be positive. Down the line, investors that have been able to preserve capital may find some interesting opportunities to rotate into risk assets should market conditions improve.
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This article was written by
15 years of professional experience in capital markets and investment management at major financial institutions.
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Analyst’s Disclosure: I am/we are long VGSH. 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.
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