- Inflation gauges are starting to pick up, driven by economic reopenings and continued high levels of government stimulus.
- As prices rise, the Fed will have more pressure to raise rates. As yields and rates increase, long-term bonds in particular will get hit hard.
- BLV is a smart play if one expects an equity pullback. Given elevated valuations, this is possible. However, the downside risk for BLV is quite high if inflation and equities keep trending up.
- This idea was discussed in more depth with members of my private investing community, CEF/ETF Income Laboratory. Learn More »
Main Thesis and Background
The purpose of this article is to evaluate the Vanguard Long-Term Bond ETF (NYSEARCA:BLV) as an investment option. This ETF has a primary objective "to track the performance of the Bloomberg Barclays U.S. Long Government/Credit Float Adjusted Index." Currently, the fund trades at $100.02/share and pays monthly distributions, with a 30-day SEC yield of 2.88%. I covered BLV for the first time back in October, when I presented a mixed review of the fund. In hindsight, I probably should have been a bit more bearish, as BLV has seen a measured drop, while equities have soared:
Source: Seeking Alpha
In fairness, BLV did hold up reasonably well during the volatility we saw late last year, but that trend did not continue into 2021. In fact, the story of this year has been risk-on in a very consistent fashion. This is making hedges less attractive, and the market has been rewarding those who are willing to go overweight on the momentum plays.
Looking ahead, I continue to see merit to hedging this market, given how expensive equity markets are looking. However, I would balance this out by saying the macro-environment remains in favor of equities, especially those in cyclical areas. As global economies reopen, vaccine distributions reach more people, and employment figures strengthen, the story of the second half of the year is likely to be one of growth and inflation.
Under these scenarios, long-term bonds are sure to suffer, while cyclical sectors with more price elasticity will outperform. Of course, if the second half of the year does not go as planned, then equities will take a breather, and those with hedges will be rewarded. But investors have many ways to hedge against an equity downturn, and there is simply too much duration risk in a fund like BLV for me to recommend this option as the best way to do so.
The Pressure On BLV Is Well-Justified
To begin, I want to take a look at the driving force behind the recent weakness in BLV and long-term bonds as a whole. Simply, this has been a strong economic recovery, driven by state and local reopenings and rising employment figures. With more businesses opening their doors and people getting back to work, the broader economic outlook is looking much better than it did even a few months ago. This has supported moves into riskier assets like stocks, in particular cyclical sectors. The end result has been a rotation out of fixed-income, hurting BLV in a disproportionate way.
Of course, a more optimistic outlook is not the only factor harming long-term bonds. Of note, we are starting to see inflation readings pick up, something that has not happened in a year. In fact, the CPE index has moved sharply higher in the short term, suggesting that prices could have further to climb:
Source: S&P Global
Now, some may see this as good news, and it does suggest the economy is in a much healthier place. But, when evaluating BLV as an investment option, this is not good news at all. The reason is, as prices increase, so do current and future inflation expectations. That pushes yields higher, and can also act as a catalyst for higher interest rates. This scenario will disproportionately hurt long-term bond funds, like BLV, because of the extended duration of the fund.
Importantly, bonds serve to balance out a portfolio to protect against equity pullbacks and provide income. But this is true of many types of bonds. Where they differ is in their interest rate sensitivity, which is measured by duration. BLV, with its long-term focus, has a very high duration level and, thus, is very interest rate sensitive. The good news is, its duration has come down slightly since late last year, from over 16 years to just over 15.5 years, as seen below:
The bad news is, this is still a very interest rate sensitive fund.
Of course, if market conditions worsen and/or central banks delay interest rate hikes, long-term bond investors will do fine. But this amount of duration risk is quite extreme to take that chance, in my opinion. With macro-fundamentals on the upswing, it seems most likely that yields will end the year higher, not lower. If that does happen, BLV could have a long way to fall, given that the fund is expected to drop by roughly 15% for every 1% increase in interest rates. This trade-off makes it very difficult to recommend BLV as a way to play potential equity volatility.
The Story Isn't All Bad
While I do see a lot of risk in a position in BLV at the moment, I do want to emphasize that I am not "bearish" on this fund. Long-term bonds have already taken a pretty good beating, and there is a chance that pain could subside. While rising consumer prices and economic reopenings are pushing up longer term yields, the Fed is working to moderate further increases. Additionally, the Covid-19 pandemic is nowhere near over. We are still seeing people die by the hundreds every day in America, and there is a surge in India and other parts of the world. This could limit global growth, and cool the ever-rising equity market. Under those conditions, long-term bonds stand to perform moderately well.
The Fed piece is particularly important. While some market participants believe the rising price levels will accelerate in the second half of the year, forcing the Fed to act, the Fed does not share that belief. While this is a debatable subject, the Fed currently holds the cards, and Fed Chairman Powell has categorically ruled out near-term rate increases. Last Wednesday, Chairman Powell issued a statement with a very dovish tone, in which he stated the Fed will keep rates steady and also maintain asset purchases at their current level. This reassured markets, and took the pressure off of yields for the time being. Ultimately, this dovish policy helped BLV nudge higher in the past few sessions, as shown below:
Source: Seeking Alpha
My point here is to manage expectations. While I am reluctant to put my money to work in BLV, I do see some positive catalysts. This is especially true if economic data disappoints over the next few months. Thus, there are some reasons to remain long, if one already is, and I wouldn't advocate going short on this sector either for the time being.
These Are Global Trends
My final point looks at what are some global trends, to further support my cautious outlook for BLV. Importantly, investors do not invest in U.S. bonds, long or otherwise, in isolation. While yield pressures have subsided somewhat over the past month, readers should note that rising yields are a global story so far in 2021. This is true in the U.S., and across the developed world and emerging markets, as shown below:
My point is that even if the Fed works to control rates domestically, they could still climb in other areas. This could make foreign bonds more attractive by comparison, pushing down the relative value of BLV.
While readers may surmise that other nations will follow the U.S.'s lead, we are already seeing some nations diverge. For instance, the Bank of Canada already announced intentions to cut back on their easing. Two measures of note are listed below:
- Signaled it could hike interest rates as soon as next year (2022)
- Cut the pace of bond purchases to $3 billion (Canadian)
Source: Bank of Canada
At the same time, the Canadian government announced plans to increase its bond issuance to the tune of C$121 billion years or later, up from C$107. (Importantly, these are long-term bonds maturing in 10 years or later). The result was a sharp rise in yields, as displayed below:
My takeaway here is that investors need to recognize that higher yields and central bank tightening have the potential to be global trends in 2021, and beyond. While the Fed might lag its peers, if we see other countries pursue similar measures, that will undoubtedly challenge expectations for higher yields here. Taken together, this potential presents a major headwind for BLV, along with other long dated funds. Simply, if you are optimistic on the global recovery, you probably should not be optimistic on BLV.
BLV has a few positive attributes, such as a level of income higher than savings accounts, CDs, or short-term bonds. Similarly, the fund will act as a hedge against equity volatility, which investors could find useful if they are concerned about ever higher index prices. Further, if the Fed keeps up its asset purchases of treasuries and mortgage-backed securities, that will provide underlying demand for BLV's holdings.
Despite these positives, I must caution against being too optimistic on this investment play. The fund is extremely sensitive to changes in interest rates, and that poses a problem if the economic recovery continues to strengthen. While the Fed has maintained a dovish stance, that could change if financial conditions and inflation measures force it to act. Finally, other central banks, such as our neighbor to the north, are already starting to signal plans for higher interest rates. That has driven yields higher in Canada, and is likely to have an impact on other nations as well.
As a result, I would suggest a cautious approach to BLV, and very selective buying only if one is expecting an equity sell-off and is able to withstand the potential interest rate risk. Therefore, my neutral outlook on BLV remains unchanged, and I will continue to look elsewhere for diversification at this time.
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This article was written by
I began my career in financial services in 2008, at the height of the market crash. This experience has shaped my investment strategy - which is focused on diversification, dividends, and growth opportunities. I am a competitive tennis player, and I competed at the Division I level in undergrad. I have a Bachelors and MBA in Finance.(He is a contributing author for the investing group CEF/ETF Income Laboratory where he specializes in macro analysis. Features of CEF/ETF Income Laboratory include: managed income portfolios (targeting safe and reliable ~8% yields) making use of high-yield opportunities in the CEF and ETF fund space. These are geared toward both active and passive investors of all experience levels. The vast majority of holdings are also monthly-payers, for faster compounding and steady income streams. Other features include 24/7 chat, and trade alerts. Learn more.)
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