VCIT: Good Return, But The Market Has Already Priced In A Few Rate Cuts Already

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VCIT: Good Return, But The Market Has Already Priced…

ETF Overview

Vanguard Intermediate-Term Corporate Bond ETF (VCIT) focuses on intermediate-term investment grade corporate bonds. The ETF tracks the Bloomberg Barclays U.S. 5-10 Year Corporate Bond Index. VCIT has very low credit risk as all of the bonds in its portfolio are investment grade bonds. However, the fund may underperform against other treasury ETFs as over half of its bonds belong to the lowest level investment grade bonds. The fund has moderate interest rate risk due to the fact that its portfolio of bonds has an average duration to maturity year of 7.5 years. The ETF offers a 3.4%-yielding dividend. It is a good investment choice for conservative investors with a long-term investment horizon, as it offers an average annualized return of 5.67%.

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Data by YCharts

Fund Analysis

Low credit risk

We like VCIT’s strategy to invest in investment grade corporate bonds as investment grade bonds have much lower default rate than high yield bonds. In fact, investment grade bonds’ default rate is only about 0.10% per year (based on 32-year period measured). On the other hand, default rate for below-investment-grade bonds is about 4.22% per year. This makes it a better choice than high-yield bonds when the economy is heading for a downturn.



Source: Vanguard Website

Lower quality investment grade bonds may underperform other treasury bonds

Although credit risk is low for VCIT, investors should keep in mind that nearly 50% of the funds are Baa rated bonds (see chart above). Baa rated bonds are at the lower end of the investment-grade credit spectrum. Hence, in an economic recession, some of these borderline issuers may see their ratings downgraded. Therefore, these bonds are still considered riskier than the U.S. treasuries. Given VCIT’s high exposure to lower quality investment grade bonds, its fund will likely underperform other U.S. treasury ETFs. Since VCIT’s inception was after the Great Recession, we do not have enough past data to compare its performance with another treasury ETF. However, last year’s market correction offers a glimpse of how VCIT might perform in a bear market. As can be seen from the chart below, VCIT’s fund price declined by 1.5% from the end of September 2018 to December 24, 2018. On the other hand, Vanguard Intermediate Term Treasury ETF (VGIT) delivered a positive return of 1.6%.

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Data by YCharts

Moderate interest rate risk

VCIT’s portfolio of bonds has an average effectivity maturity year of 7.5 years. This is shorter than many long-term bond ETFs (10~20 years) but longer than short-term bond ETFs (less than 5 years). Its intermediate maturity term means that the fund’s performance is only moderately sensitive to the change of interest rates. As can be seen from the chart below, VCIT’s fund performance is still inversely correlated to the 10-year treasury rate.

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Data by YCharts

A 3.4%-yielding dividend

VCIT investors will receive dividends with an annualized yield of about 3.4% on a trailing 12-month basis. This dividend is safe as these bonds are investment grade bonds with very low default rate.

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Data by YCharts

Macroeconomic Analysis

The current economic cycle has been well into its 10th year. Nevertheless, there are already many signs that we are in the late cycle environment. For example, we are seeing signs of investors rotating from riskier assets (e.g., energy, industrial, etc.) towards defensive sectors (e.g. telecom, utilities, some REITs, etc.). We believe investors are concerned that the escalation of the global trade tensions will lead the U.S. and global economy into a recession. However, we believe a large portion of this concern is reflected in the treasury yield already. The decline in treasury yield recently suggests that the market has already priced in 1 or 2 rate cuts in the U.S. Given VCIT’s strong fund performance since the beginning of the year, we believe its fund price has also priced-in a few rate cuts already as well. Therefore, we do not think there is much upside from this level.

Investor Takeaway

For conservative investors with a long-term investment horizon, VCIT may not be a bad choice as it generates an average annual return of 5.67% since its inception. However, we think the market has already priced in a few rate cuts in VCIT’s fund price. Therefore, we think investors can wait on the sidelines.




Source: Vanguard Website

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: This is not financial advice and that all financial investments carry risks. Investors are expected to seek financial advice from professionals before making any investment.

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