When I first got serious about investing, I read a lot of arguments suggesting that the smartest way to invest in the fixed income part of a portfolio was an intermediate term index fund. Back when I started investing in index funds, that would have meant investing in the Vanguard Intermediate-Term Bond Fund (VBIIX). Over the years that fund has morphed into Admiral share class fund (VBILX) and, since April 2007, an ETF (NYSEARCA:BIV). Since Vanguard is actively discouraging investment in the mutual fund by charging a .02% lower expense ratio for the ETF, we will discuss the ETF in the rest of this article. Keep in mind, though, that the ETF is only a share class of the mutual fund with identical holdings.
Lots of investors appear to still think this fund is the way to invest. Vanguard reports it currently has $41 billion in assets in both share classes of this fund. There are $15 billion invested in the ETF share class alone. The only larger intermediate-term bond ETF available to investors is Vanguard's Intermediate-Term Corporate Bond ETF (VCIT). It has $46 billion in assets in all its share classes, but $44 Billion of those assets are invested in the ETF share class. Morningstar ranks BIV with 5 stars, its highest rating, too.
The omission of the word "Corporate" in name of BIV doesn't mean it doesn't hold corporate bonds. It does. But Vanguard tells us that 50.3% of the fund is invested in US Treasury and Agency bonds. This explains why BIV's yield is significantly lower than that of VCIT. BIV's SEC yield is currently 1.16% compared to 1.63% for VCIT. But this higher yield comes, as is always the case with bonds, with more risk. A majority 54.58% of the holdings of the corporate-only ETF are rated Baa, which is the lowest rating given to Investment Grade bonds. Since only half of the bonds in BIV are corporate bonds, those lower rated bonds only make up 26.2% of BIV.
Vanguard tells us that the fund holds bonds with maturities of 5-10 years and that the "average effective maturity" which takes into account possible calls on bonds is 7.3 year. The yield to maturity of these bonds right now is a historically low 1.20%. That means, in the simplest terms, that if you bought all the bonds in that fund today and held them to maturity you would get 1.20% a year from them.
That number, right there, should give you pause. Would you really be willing to tie up your money for 5 years for 1.20% a year, to say nothing about ten years!
Some argue that that rate is still higher than you can get from Treasuries with the same maturity or a 5 year CD, which is true. But to feel comfortable with an investment of this nature you would have to be convinced that inflation would remain well under 1.20% for five years or longer. And if you were investing in a taxable account, you would be losing a good chunk of the meager earnings that you received as bond dividends, because bond interest is taxed as ordinary income rates. If you are investing in your IRA or 401K account, you might think this doesn't matter, but all your Required Minimum Distributions are also taxed as ordinary income rates, so any gains you get from deferring taxes are recovered unless your income at retirement including your social security is very low.
Some people in response to arguments like these say, "Bonds are for safety. The point is that you are maintaining money here that you can deploy to get bargains when stocks have one of their periodic meltdowns." This is true. As long as the NAV of your bond fund doesn't fluctuate very much. But given that very low yield, whether that is something you can rely on is very much up for dispute.
Vanguard tells us that over the ETF's lifetime since its inception in 2007, BIV's average annual returns (before taxes) have been 5.39%. Over the last three years it has averaged an annual pre-tax return of 6.53%. In 2020 its returns were even better. Before taxes it returned a whopping 9.70%, though this return shrank if you figure in the impact of taxes on both the interest it paid and on the capital gains distribution it distributed in December of 2020.
To better understand this number, I looked at the changes Vanguard reports in the share price between Jan. 3, 2020 and Dec. 31, 2020, there was an increase in share price of 5.72%. The rest of the pre-tax gain must be the dividend and the capital gains distribution paid. From the data Vanguard gives us of the annualized rate represented by the distributions paid each month through 2020 (which are calculated on the page for the mutual fund share class of this fund) it looks like the average dividend paid each month was 2.26%. That brings us up to 7.98%. There was a one-time distribution on December 23 that represented .70% of the opening share price, which would get us up to 8.68%.
All I can think to explain this is that the actual interest paid was a bit higher than the average suggests it would be. But it is still a bit mystifying. It always shocks me how little truly useful information mutual fund and ETF purveyors share with us about the investments they sell us.
Before we move on, you should note that BIV doesn't always distribute capital gains. The previous distributions were in 2017 and 2016.
But the big question on my mind is whether that 5.72% share price gain in 2020 is flashing a bright red "Danger!" warning. Because bond fund prices only go up that much when rates fall dramatically, as they did in 2020. So we really want to look at how big the rate change was that caused that surge in NAV to prepare ourselves for what happens if rates revert to where they were just a year ago.
But the reversal of that spike isn't the only consideration. The bigger issue is that during this past year the fund has been buying bonds to replace those that have aged out and it has also been buying bonds to increase the size of the ETF to take into account the large amount of money that has flowed into the fund during the year.
And how that money has flowed! Below you can see Morningstar's performance chart for BIV. Along the bottom there is a graph of fund flows. With the exception of the very beginning of the year and around the March correction due to the Pandemic, BIV saw a billion dollars more or less flow into the fund in most months.
This heavy flow suggests that there may be more than just one year's worth of bonds added to the ETF during this period, and if that is the case, many would have been added at prices that meant they were paying very low yields.
That may explain why the SEC yield of the fund as of February 16, 2021 is so extremely low: only 1.16%. That would appear to be a historically low yield for intermediate bonds. How low? Well, for comparison, we need only note that in March of 2020 the Vanguard's Prime Money Market Fund whose yield was based on the prices of the very shortest term kind of bond and which usually trail intermediate bond yields by a percent or two was yielding 1.36%--a yield that is 20% higher than the SEC yield of BIV is now.
We don't have access to a history of the SEC yields of BIV, but it is possible to download the distribution history of the ETF in a file Vanguard provides on its Advisor's site. A search of that file shows that never once in the 10 years of data that Vanguard provides had the ETF dividend per share been as low as it was on October 1, when it hit $0.15747 a share. But since then it has continued lower, with the February 1, 2021 distribution being only $0.15385. Given that the SEC yield is still much lower than the latest distribution yield (1.97%) it is likely that the distribution yield will keep sinking for some time to come, no matter what rates do.
So what we have here is a fund whose NAV rose through 2020, delighting naive shareholders, perhaps, while the payment it made to those shareholders was dropping every month.
So now what happens if rates stop dropping?
If you've been paying attention to treasury rates of late, you will have noticed that they have started moving upwards. This may be because inflation numbers are rising, what with supply chain distortions from the pandemic and, most recently, challenges to the supply of the oil. As a result, longer-term rates, which are not under the direct control of the Federal Reserve Board have risen significantly since January.
In theory, investors can tell how the price of a bond fund NAV will fluctuate based on the fund's duration. This is a number, denominated in "years." There are two different kinds of duration, but the one that Vanguard provides on its bond fund information page is "average duration." As Vanguard explains it, the duration they display is:
A measure of the sensitivity of bond—and bond mutual fund—prices to interest rate movements. For example, if a bond has a duration of 2 years, its price would fall about 2% when interest rates rose 1 percentage point. On the other hand, the bond's price would rise by about 2% when interest rates fell by 1 percentage point.
And this is where things can get ugly. Because BIV's "average duration" right now is 6.5 years. So if bond rates rise 1% you are supposed to see your NAV drop 6.5%. Is this accurate? Duration is not exact, and it can change quickly as interest rates fluctuate in the bond market.
So let's see what happened when bond rates rose more than 1% last year. Below you can see what US Treasury rates were at the beginning and end of 2000--that period when the NAV of BIV rose 7.78%. I have also put in the current Treasury rates as of February 16, 2021.
Changes in Intermediate-Term Treasury Rates
|Treasury 5 Year Rate||Treasury 7 Year Rate||Treasury 10 Year Rate||Average|
|January 2, 2020||1.67%||1.79%||1.88%||1.78%|
|December 21, 2020||.36%||.65%||.93%||.64%|
|February 18, 2021||.57||.94||1.27||.92%|
As you can see, average rates for intermediate term Treasuries (which make up fully half of BVI) dropped 1.14% over the course of 2020. Corporate rates tend to vary quite closely with Treasury rates, though they are higher. Were the duration figure Vanguard gives us a precise prediction of rate behavior, we would have expected to see a rise in BIV's NAV or 7.41%, (1.14% X 6.5). However, the actual rise in the NAV price was 7.72%, which is about 4% higher than the prediction.
That said, we have no way of finding out what the duration of the fund was on January 1, 2020, because the people who sell us funds never give us that kind of data, which is the data that could let us get a much better idea of what we are buying. Perhaps the duration of the fund was a bit lower at that time. Investopedia tells us this important fact about how duration works:
A bond’s coupon rate is a key factor in calculation duration. If we have two bonds that are identical with the exception on their coupon rates, the bond with the higher coupon rate will pay back its original costs faster than the bond with a lower yield. The higher the coupon rate, the lower the duration, and the lower the interest rate risk.
So if the fund acquired a significant number of bonds paying coupon yields more than a percent lower than what it had previously held, that would cause the duration to rise.
In any case, this past behavior tells us that we should expect the fund to drop at least 6.5% if there is a 1% rise in rates. We have already had a rise in Treasury rates of .28% this year, as you can see in the table. Between January 2, 2021 and February 16, 2021 when that drop occurred, the NAV of BIV dropped 1.78%. This is only a few basis points less than the 1.82% that the NAV should have dropped according to that 6.5 year duration.
So yes, duration is pretty predictive for this ETF and if we did see a steady rise in rates, we would see a steady decline in NAV, at the same time that the ETF's distributions would remain in the 1% range for some unknown time that we can't estimate given that we know nothing about the actual yields and maturity dates of the 2,133 individual bonds that make up BIV's holdings. We don't know anything about the strategy that the ETF uses to roll off bonds as their maturities shorten either.
From reading discussions of bond fund investing elsewhere, I have come away impressed by how little many otherwise highly educated, high earning professionals seem to understand about how bond prices work. I continue to see people showing graphs of bond returns stretching back 20 or 30 years to prove that bonds always provide safety. I continue to see people posting a misleading chart provided by Vanguard, which points out that historical drawdowns in bond funds have been much smaller than those in stock funds and that bond prices quickly recover from such drawdowns in the next year or two.
All of this is true, but it ignores the fact that bond yields started in the high teens back in the early 1980s and have come down very, very slowly ever since. Periods in which rates rose were indeed brief, and the amount by which bonds rose was relatively benign.
Most importantly, the interest bonds--and by extension bond funds--were paying during the whole period for the early 1980s until now was high enough to absorb a percent of decrease while still paying enough monthly interest to make up for those temporary drops in the price of their shares. I feel differently about a drop of 1.5% in the value of my fund's NAV when I'm earning 4% than I do when that same fund's NAV drops the same 1.5% but I am only earning 1.16%.
And if the rise in interest rates is not a brief blip--if rates ever were to crawl back up to what most of us geezers considered to be insultingly low rates--5%, for example, owning a portfolio of bonds with 5 to 10 year maturities that pay us a yield of only 1.16% starts looking mighty lame. Yes, eventually the rising interest rates paid by newly bought bonds would increase your true yield and stop the deterioration of the NAV, but eventually could be a long time given that the fund is full of bonds with maturities of 5 to 10 years.
It has become common to laugh at people who worry about rates going up. Those of us who did worry, and thus avoided investing in medium and long-term bonds, have left a lot of money on the table over this past decade. People now speculate that even though the Fed's overnight rate it charges banks (the only rate it controls) is close to zero, nominal rates could still go lower. They point out that negative rates have been offered in Germany for some years now. If rates drop below 0%, your bond fund NAV will continue to rise, though over time your negative coupons will further reduce the tiny interest payments you get. If they lasted long enough, might start decreasing your NAV each month.
The Fed has also shown us this year that it will do more than just buy Treasuries to keep rates artificially low, as it also ventured into purchasing corporate bonds in June of 2020 as a result of the CARES Act. What else might the Fed do to keep rates low? Who knows? I sure don't, and because I don't, I find it very hard to imagine what interest rates, and hence BIV, might do in the future.
But that said, I always like to figure out whether the upside of an investment is significantly more rosy than the downside. Right now the upside of BIV is a SEC yield of 1.16% and slightly higher distribution yields currently just under 2% but dropping every month and likely to keep doing that for some unknown time period.
Vanguard tells us that the total return of the mutual fund version of BIV is currently -1.50% for the year after a .28% rise in interest rates. People who argue that bonds are for safety rightly point out that this is the amount that stocks often fluctuate in a single day and considerably less than the drop in stock fund NAVs you will see during a correction.
But if the rates were to rise as much as they fell last year, the fund's total return would likely be a loss of 7% minus whatever percent the monthly distributions end up being of the NAV. That might end up being about 5.5%. If rates were to keep rising for another couple years the NAV could drop another 5% for another couple yearse. Yes, fund would own more bonds bought at higher prices, so the slide would end, in time. But with such low rates, the kind of duration measurement that tells you how long it takes to get back to even on your NAV could stretch out to 6 or 7 years for the fund to recover from each 1% rise in rates.
Furthermore, if rates continued to rise, you could see persistently decreasing NAVs. That could spook the many naive investors who looked at charts of past performance and assumed bond funds always went up. That might discourage a lot of investors from putting their money into bond funds in favor of Bank CDs.
Where things get interesting in that scenario is what happens if the heavy in-bound flows we saw this past year reverse as rates go up. Does that catalyze a "rush for the exits?" It could. There was a brief rush for the exits last March and it severely depressed the NAV of BIV, albeit for a short time. The NAV of BIV dropped from $92.22 on March 6 to $83.77 on March 19. This represented a drop of 9.16%. That drop was halted by the Fed's promise to buy corporate bonds and the subsequent recovery of the market. Would a future drop resolve so easily?
Let's do some worst case thinking here: Besides a rush to the exits, there are some other possible issues to consider.
All these scenarios might sound far fetched, but they all have non-zero probabilities of occurring. Does a potential yield of 1.16% offset even a 20% chance of any of them happening? Would you be happy waiting 6-12 years--or more to get your investment back from a bond market that results from rates climbing back to the 7% levels they were at in the early 2000s?
For me, the answer is no. I can get a completely risk free, FDIC insured .60% yield in Live Oak Bank's online bank Savings Account. I can get .50% at Ally Bank in a 11-month No Penalty CD that I can break at any time without paying any Early Withdrawal Penalty. So the difference between taking some undefinable amount of risk and of taking no risk is .56% more annual yield. That is using that SEC yield as a gauge of BIV's future yield.
If rates go up 1%, I can take my money out of the bank and buy a better No Penalty CD. (The ones I bought last spring were paying 1.79%.) If rates go up 2%, taking them back to where they were just two years ago, I could possibly find 3.5% and 4% CDs like those that were around at the end of 2018 and into the spring of 2019.
Decades of declining interest rates and rising bond ETF NAVs have lulled investors into thinking of bond funds as a way to preserve capital and also provide "dry powder" with which to buy stocks when they have one of their periodic downturns.
But the extremely low rates that we saw this past year, lower than anything ever seen by everyone who started investing from the early 1980s on, have changed the risk/reward balance for an intermediate-term bond fund like BIV.
If you are going to park money for safety, you might be better served investing in a fund with a shorter duration (if you are lazy) or a bank or credit union CD (if you don't mind doing half an hour's work now and then.)
Taking significant principal risk for a 1.16% yield makes no sense to me. Yes, it is possible that bond rates will drop into negative territory, pushing up your NAV further or that the Fed will continue inventing new forms of perpetual motion for the bond market. But it was also possible that GameStop would go up another hundred bucks or so after it hit $400. You never know. But I do know that greed never pays. So I just can't see any reason not to declare victory, congratulating yourself on the hefty returns BIV has paid over the past decade, and moving your money somewhere that truly offers safety for your principal, no matter what the yield.
So that's my take on it. What's yours?
This article was written by
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: I am not a registered investment analyst, but merely an alert amateur investor who uses the research involved in writing articles like this one to clarify my thinking about the securities I buy for my own portfolio. I currently have invested a significant amount of money in Life Oak Bank, but have no other relationship with them save to be a customer.