- BLV is a bond ETF that closely tracks the Bloomberg Barclays U.S. Long Government/Credit Float Adjusted Index.
- Almost 45% of its holdings comprise of long-term US Treasuries with the remaining exposure distributed across different investment-grade bonds.
- Historical returns have been high on account of falling interest rates.
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"The individual investor should act consistently as an investor and not as a speculator." - Benjamin Graham
Looking at the performance of bond ETFs in the past month has presented an interesting investment opportunity. The share prices of most of these ETFs have been surging towards their 52-week highs. While the Federal Reserve (Fed) rate cuts have been a boon to fixed-income investments, ETFs like the Vanguard Long-Term Bond ETF (NYSEARCA:BLV) present investors with an opportunity. Many argue that without any further rate cuts, the appreciation of bond ETFs may be limited. Also, the ETFs are no longer available at deep discounts to their net asset values. While this may be right to some extent, other features of this fund make it worthwhile for further consideration.
A Stock of Quality Bonds
Source: Seeking Alpha
The fund replicates the Bloomberg Barclays U.S. Long Government/Credit Bond Index and has returns that are almost equal to the index. This suggests that the fund has been able to replicate the index's performance to a great extent.
The debt fund has been able to achieve substantial returns despite the risk being low while looking at the past returns in the ETF. A 10-year return of 8.04% with a portfolio comprising of high-quality bonds is a tempting proposition but can be challenging to achieve. Those are equity-like returns over the long run.
A significant part of the returns has been contributed by the fall in yields over the years with the move to quantitative easing and dropping of interest rates to rock bottom. It is widely understood that even when rates do rise, the new normal interest rate will be far lower than in the past. The 30-year Treasury yield at the inception of 2007 was 4.79% - it currently stands at 1.37%. When considering the high duration of the bond, it is natural for the price of these bonds to appreciate significantly as the yields fall. The fund's maturity also reveals that these bonds were bought when the rates were substantially higher than in the current scenario.
Can this type of return be sustained in the current environment, in which there is little scope for appreciation if the Fed leaves rates unchanged?
What can drive future returns?
Indeed, the gains that the fund realized through the drop in yields could be difficult to emulate in the future, given the existing Treasury rates are quite low. While a negative rate cut cannot be ruled out altogether, there are opportunities in the corporate bond segment which the ETF may exploit. These bonds generally have a higher yield and can help the income investor take advantage. Looking at the credit spreads in the current scenario can indicate why there is a case for investing in good quality corporate bonds.
Spreads of corporate bonds continue to be significantly higher than the historical average. Even if we ignore the high-yield segment, the overall market is almost 1% higher than the spread observed in the past few years. If economic conditions return to normal as the economy reopens, these should fall back into place. Corporates have had to compensate investors with additional returns to invest in these bonds.
There has also been a surge in volumes in the bond market activity after the COVID-19 situation arose. Corporations have been looking for additional cash to beef-up their balance sheet in this crisis. Investors, however, were lured in with higher returns for the extra risk. With the Fed also pitching in to buy investment-grade corporate bonds recently (and even some high-yield bonds), the additional demand could be a relief for corporations borrowing, giving them more flexibility in reducing the rates, even when they assume higher leverage.
What are the risks involved?
The following risks should be considered while making an investment decision in the ETF.
Interest Rate Risk: As stated earlier, the current rate set by the Fed is almost zero, and negative rates have been dismissed by the Fed recently. Given the high duration of the fund, any rise in the rates could create a dent in the ETF returns. Investing in funds with long durations can be a double-edged sword and needs to be considered before investing. Interest rate risk could also arise from the need for investment coupons and principal repayments at a lower rate.
Widening of Credit Spreads: The fund has been able to pick high-quality corporates that have generated generous returns for the fund. Following a similar trajectory can be risky in this current situation. While there are investment-grade bonds providing higher yields, the impact of leverage cannot be ruled out on the creditworthiness of these firms. Since future returns of the ETF relies heavily on the performance of highly-rated bonds, there is a likelihood that sustained economic slowdown could increase the credit spreads of the corporate bond market.
Credit Risk: While investment-grade bonds are providing higher yields, the impact of leverage cannot be ruled out on the creditworthiness of these firms. The chance of this happening is remote, given the credit quality of the portfolio, but it should not be ignored completely. The pandemic has managed to rattle the foundations of seemingly steady businesses, and this could impact the companies that are existing in the fund. There have already been some significant bankruptcies announced by J.C. Penney (JCPNQ), Hertz (HTZ), and Neiman Marcus (NMG-OLD), among others.
Given the history of substantial returns in a fund with highly-rated issuers, BLV certainly makes a case for itself in replicating the performance in the future. With the corporate bond market building momentum, the fund should be able to pick good quality bonds to enhance future returns. However, investors should be aware of the high interest rate risk that the fund poses on account of the duration of its holdings. It might be worth waiting for a better entry point, but in the long term, this is a play on America's corporate healthiness overall. As Uncle Warren (Buffett) has stated several times, it is not smart to bet against America.
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