2 Reasons To Buy VGLT Today

Summary

• VGLT has taken a beating since the start of 2022, but that only makes it a more attractive investment today.
• VGLT is the ideal choice for hedging against equity drawdowns from an overall portfolio standpoint, as compared to short- or intermediate-term bond funds.
• VGLT reverts back to the mean - always.

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The year 2022 is a great year to get into bonds, and the Vanguard Long-Term Treasury Index Fund ETF (NASDAQ:VGLT) is an excellent choice. Investors with a long time horizon will find this fund to be a safe vehicle that compliments any stock allocation with minimal fees. VGLT's return is bound to outpace that of other bond ETFs in the long term and may even provide capital gains in the short term.

The Common, And Debatable, Complaints About Long-Term Bonds

I know that my thesis above raises red flags for reasons other than the fund being down 17% YTD. Long-term bonds have a history of being looked down upon. Many investors claim bonds are best used as a hedge against an equity downturn, citing the adage "bonds are for safety". Ergo, long-term bonds are invalidated due to their vulnerability to inflation and interest rate risks. Besides, if an investor has a long time horizon, they might as well allocate their cash to stocks.

All of these points are correct, but as a skeptic, I think that there is more to the story. I present two arguments for why long term bonds do have a place in a long term investor's portfolio even under current market conditions.

1. Long-term bonds fight against the volatility of stocks better than any other type of bond.

2. Bond funds always revert to the mean, and that includes fighting back against this year's runaway inflation and interest rate hikes.

But, first, it is important to clarify why I like VGLT specifically.

Why VGLT Beats The Rest

VGLT invests in 66 bonds with an average effective maturity of 23.8 years and an average duration of 17.6 years. This is in-line with the Bloomberg US Long Treasury Index which it tracks. The annualized yield since inception is 5.23%. This is higher than the current 30-day SEC yield of 2.88%, but that is to be expected. This does not beat the average return of equities, but bonds are an entirely different asset class, so the comparison is not fair. Compared to the Vanguard Total Bond Market ETF (BND) at 3.53%, VGLT is "beating the bond market" by taking on more risk in the form of duration despite having less default risk of the underlying securities. VGLT does all of this with an expense ratio of 0.04%.

There are many long-term bond ETFs, but I prefer VGLT. Morningstar's Fund Comparison tool notes that the iShares 20+ Year Treasury Bond ETF (TLT) has an expense ratio of 0.15%, which to me already makes me look away considering the competition is cheaper. Comparable to VGLT are the SPDR Portfolio Long Term Treasury ETF (SPTL) at 0.06% and the Schwab Long Term US Treasury ETF (SCHQ) matching at 0.04%. SPTL and SCHQ's duration and 30-day SEC yield are comparable. I do not see any compelling reasons to value any of these ETFs over another, but VGLT has been in existence longer than SCHQ and is slightly cheaper than SPTL. I have to pick one ETF, and therefore, my vote goes to VGLT.

In the spirit of highly volatile bond investments, I must mention that Vanguard's Extended Duration Treasury ETF (EDV) is an attractive candidate. However its 30-day SEC yield is 2.95% with an average duration of 24.6 years. While I don't think the 0.07% extra yield is worth an extra 7 years of duration risk, it can be attractive to some retail investors. Notably, EDV deals primarily in Treasury STRIPS instead of traditional bonds, which drags it further away from the realm of traditional bond investments. Vanguard places EDV in its highest risk category and recommends retail investors to consult a professional before investing in it. I would advise the same. While I would personally be willing to get in touch with a fiduciary to discuss investing in EDV, I would invest in VGLT in a heartbeat. VGLT does not come with warning labels on the package.

Now, I should explain the two reasons why I am bullish on VGLT.

1. Bonds Are Safety For Your Portfolio - Not For Your Cash

A classic argument against long-term bonds is that investors ought to take risk on the equity side, and use bonds as low-risk fixed-income instruments. There is certainly nothing wrong with this elegant idea, and investors who adhere to it for a lifetime are sure to be rewarded handsomely. However, I view all of this as mental accounting.

A retiree who relies on their investments is going to withdraw not from their bonds, but from their overall portfolio. They will do this in accordance with what their investment policy statement says about rebalancing. This will generally be withdrawing from the assets that have appreciated in value. If the bond market falls, they would withdraw from their stocks. If the stock market falls, they would withdraw from their bonds. The idea that bonds provide safety, in this case, does not depend on the bonds' duration, but instead the fact that bonds are held at all. By this logic, VGLT should be providing just as much safety as the more popular BND does.

A retiree who has correctly planned their retirement also plans to live off of their portfolio for at least 20 years - Fidelity plans for 26 years. Why, then, would a retiree not choose a bond fund with average bond duration matching their time horizon? VGLT then becomes the better investment.

What really matters here is the stability of your overall portfolio, not the stability of your leftover cash that you didn't shove into stocks. I call the conventional wisdom a form of mental accounting because many investors who shy away from long-term bonds are not thinking in terms of their overall portfolio. If you want overall portfolio stability, then you want to benefit from the slightly negative correlation against stocks that long-term bonds offer. Leveraged funds like the WisdomTree US Efficient Core Fund (NTSX) utilize this methodology to great effect. However, I am not a fan of NTSX concerning its particular use 7-year duration bond futures. I believe that long-term bonds offer a similar risk parity advantage to NTSX's approach without the leverage. This alternative approach - increasing duration instead of margin - makes long-term bonds appropriate for an average retail investor.

Below is a diagram of three portfolios. All portfolios use Vanguard's oldest index fund share classes for the Total Stock Market (VTSMX) labeled TSM, Short-Term Treasury Bonds (VFISX) labeled Short Bonds, Intermediate-Term Treasury Bonds (VFITX) labeled Intermediate Bonds, and Long-Term Treasury Bonds (VUSTX) labeled Long Bonds. VUSTX is identical to VGLT but gives us more backtesting data. I intentionally lowered the equity allocation of certain portfolios to illustrate the risk parity that is achievable even in the absence of leverage.

Long-term bonds allow you to get away with a lower equity allocation while securing a reasonable return. (Portfolio Visualizer)

The portfolio with Short Bonds, in blue, has 80% in TSM but still equals the return of the Long Bonds portfolio, in yellow, that only has 50% in TSM. In fact, the Long Bonds portfolio has 50% the maximum drawdown and 75% of the volatility of the Short Bonds portfolio. The Long Bonds portfolio even has a 76% correlation to TSM, while the other two portfolios are at 99% and 100%.

One can argue that the chosen stock-bond allocations are misleading because the 50/50 portfolio will obviously have a lower correlation to equities. The purpose of the above diagram was to showcase that VGLT can be used to reduce your equity risk while still securing equity-like returns; I think the point is illustrated regardless of the asset allocation choice. However, we can also try fixing the stock-bond allocations to all be 60/40.

Long-term Treasuries still outperform when asset class allocations are fixed. (Portfolio Visualizer)

In this case, the Long Bonds portfolio, in yellow, outperforms on a total return basis. Not only that, it has a comparable standard deviation to the other two portfolios - thus having larger Sharpe and Sortino ratios - and has a lesser max drawdown. Its market correlation is 86% compared to 98% and 96% of the Short Bonds and Intermediate Bonds portfolios in blue and yellow, respectively.

Long story short... rather short story long: If you want bonds to hedge your equity risk, you need Long Bonds. VGLT will get you what you need.

2. VGLT Reverts To The Mean No Matter What

Secondly, bond funds naturally revert to the mean. Right now, VGLT is getting hammered by inflation and rising interest rates, which actually makes now a prime buying opportunity. VGLT is trading at a discount, but moreover, VGLT stands to produce capital gains in the short term.

It is true that every 1% increase in interest rates constitutes a ~17% drop in VGLT. This pretty much already happened over the last 4 months. What many bond detractors miss, however, is that the opposite also holds true. Rates will eventually fall again, and resulting capital gains will refund present capital losses. For prospective buyers, we have already dodged the 17% drawdown and are now looking at 17% upside potential.

The reversion to the mean concept also underscores that interest rate risk doesn't need to happen both ways for VGLT to recover. Because the US Government has unparalleled credit, your underlying bonds are definitely going to mature, and you're definitely getting your principal back. After you get your principal back, the new bonds VGLT purchases will trade at a higher market value than the old bonds. Reversion to the mean in this case takes longer but still happens. We are still looking at 17% upside potential.

In fact, it would be a good thing for long-term bonds if interest rates never go back down because VGLT will then be holding higher-yielding bonds. Our principal is refunded, and we get higher future yields to boot. Bogleheads advisory board member nisiprius has an artfully-worded explanation about this. I do not want to copy his plots here to respect his intellectual property, but they are accessible via his own forum post.

The logic that applies to interest rate risk also applies to inflation risk. While higher than expected inflation will kill the real returns of VGLT, VGLT stands far above the other bond funds during periods of deflation because long-term bond funds do not "reset" their yield on short notice. Besides, we can't control inflation, so what are we going to do? We either invest in TIPS or take what the market has to offer. VGLT's bonds are the highest yielding that the market has to offer. In either case, one thing is certain: the risk premium. Long-term bonds are champions of the risk premium. As an analogy, I would prefer to lump sum my cash into VGLT instead of "duration cost average" into BND.

When rampant inflation and quantitative tightening end, and they will, I venture that VGLT will be just fine. DM Martins Research agrees, and even suggested buying VGLT months before the current drawdown. Whether these NAV-killers end soon or in a few years is anyone's guess. If the market knew what would happen, then its expectations would already be priced in. I would guess that VGLT stands to drop another 10-15% before all of this is over, but this is mere speculation. Moreover, I don't need to perfectly time the bottom to be making a good decision. All we know is that right now, VGLT is on a discount that we haven't seen for decades. A fire sale on a security with a built-in premium doesn't sound very scary. That's just a good deal.

Buy VGLT If You Can

I do not own any shares of VGLT in my portfolio even though I really want to. Holding it in my taxable account would generate unwanted taxable flows, and my Roth accounts are tied up in stocks. I do not have access to specifically VGLT in my tax-deferred accounts, but I would jump in if I had access to it. There is no reason for me to deviate from my desired asset allocation, and VGLT is not compelling enough for me to reconsider at this time. I do implement a long-term bond strategy in my own portfolio, but just not with VGLT.

To me, it's obvious and simple: choose the bonds with the same duration as your time horizon. For most people, the time horizon might as well be forever. Indexing the total bond market sounds like a good thing, but the "diversification" benefit is nonexistent because there are already virtually zero credit risks with US Treasury bonds. I want to choose the bonds that work for my situation instead of adhering to the "own the market" dogma that works for stocks. And if my desired bonds are on sale, then there's all the more reason for me to buy.

I cannot strongly recommend VGLT because the decision ultimately depends on the investor's personal situation. That being said, I think it's unlikely that an investor would be totally incompatible with any long-term bond fund whatsoever. With a very low expense ratio and passively managed by one of the behemoth fund managers in the modern era, there are few bond funds I would recommend more than VGLT. If you can afford to wait, then you will be rewarded for the risk you take. Even if you can't afford to wait, you'll probably be able to cash out much earlier.

Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such 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.