Vanguard Short-Term Bond ETF (BSV): Burning Despite Short Duration
The Vanguard Short-Term Bond ETF (BSV) is a traded index fund offering investors access to a large part of the universe of short-term fixed income securities. The fund posted stable performance thanks to high quality holdings and a short-term orientation. However, a high inflation rate calls into question the fundamental thesis of short-term funds like BSV. Typically, investors use short-term fixed income securities as an alternative to cash, hedging against inflation while exposing themselves to very little risk.
The focus on the short term has been successful in mitigating volatility, especially compared to longer-term competitors such as Vanguard’s medium- and long-term funds. This has become particularly important in recent weeks as rising rates hurt bond funds.
Investors looking to take on little risk while earning a productive return may find BSV’s thesis appealing. Although the fund’s distribution has suffered from falling rates, the fund’s safety and low expense ratio make it a viable option within its peer group. BSV offers investors the opportunity to access a significant share of the domestic investment grade fixed income market. The fund is large with approximately $75 billion in assets under management. Let’s dive into the portfolio and see what BSV has to offer.
BSV is well diversified in terms of issuers and credit rating. With a huge and well-diversified portfolio, BSV has been able to spread risk very effectively. Although the fund is limited to bonds with a maturity of less than five years, the fund still holds nearly 3,000 individual bonds. More than two-thirds of the portfolio (67%) is allocated to public debt. The rest of the portfolio is allocated to higher quality corporate debt. The largest sub-allocation within corporate credit is rated BBB, followed by A. It should be noted that the allocation of issuers is more diversified than that of other fixed income funds. Often this is the result of a wider range of securities available in that maturity range. Compare that to a longer-term fund such as the Vanguard Long-Term Bond ETF (BLV). BLV can only invest in bonds with a maturity of less than ten years. Consequently, the fund is limited to issuers wishing to borrow with long maturities.
The fund aims to provide exposure to short-term fixed income securities, which means that bonds maturing outside the next five years are almost entirely excluded. As an indication, 1.0% of the portfolio has a maturity outside of 5 years. Over time, these positions will fall into the five-year range in a short time.
The focus on the short term results in a weighted average maturity of 2.9 years and an effective duration of 2.8 years. The duration of the fund presents a relatively low level of interest rate risk for investors. If interest rates rise by 100 basis points, the fund risks losing around 3% of the net asset value over this period. While not necessarily an earth-shattering move, it is likely to eclipse the interest income generated by the portfolio during this period.
This risk has come to the fore in recent weeks as rising rates have begun to affect BSV’s net asset value.
Returns within the portfolio are low, which is not necessarily unexpected for a short-term fund. Bonds are generally fully priced as they approach maturity, resulting in limited volatility, but also limited upside potential. The portfolio has an average coupon of 1.9% and a yield to maturity of 1.0%.
BSV is simple and effective in what it offers. Investors can access a portfolio of investment-grade and government-issued securities in a scalable, tax-efficient and transparent vehicle. With impressive price stability and monthly distributions, the fund has been a reliable player since its inception.
The fund has provided reliable income to shareholders without substantial hesitation along the way. Over the past ten years, the fund has produced annual returns of less than 2.00%, primarily due to the monthly distribution of interest.
BSV is going through dividend distributions which have declined since its inception due to falling interest rates. When interest rates fell, issuers refinanced debt at lower rates. While it is certainly beneficial for issuers who pay less interest, the fund’s dividend has suffered.
BSV has offered reliable income and stable stock prices with some appreciation to enjoy along the way. For more than a decade, the fund has posted solid performance. However, we must always recognize that past performance is not reliable of future returns. To that extent, BSV’s outlook remains weak.
In the short term, one of the biggest risks facing funds like BSV is inflation. BSV itself is a stable fund and we believe it will continue to perform in line with its objectives. However, on a broader level, investors should consider the effectiveness of short-term bonds. In the face of high inflation, we have to wonder if BSV is even capable of generating a real return. Keep in mind that the fund has never provided an annual return higher than the current rate of inflation.
Inflation has now become a crucial consideration for investors. While subdued inflation is generally not a concern as outperformance comes almost naturally, times have changed. Right now, inflation is effectively acting as a substantial hurdle rate. If investors cannot earn at least the rate of inflation, they are not earning a true return on their money. With rates at rock bottom, it seems unlikely that a further price rally is possible. Going further, it looks like no combination of rate and income changes will provide a return above 7.00% over the next twelve months.
Interest income is expected to remain stable but modest for the duration of low interest rates. A silver lining worth mentioning is the benefit of the rate hike. As issuers begin to refinance at higher rates, newly issued bonds that fall within BSV’s maturity range will include higher coupons. Coupon rate increases will result in increased monthly distributions to shareholders. However, at present, investors looking for real yield may have to look elsewhere.
After observing BSV’s problems, it seems prudent to explore strategic alternatives that may offer real returns. Given the depth of the investment universe, we will stick to relatively close competitors, excluding certain riskier categories such as business development companies, closed-end funds and other classes fixed income assets exposed to higher leverage.
We certainly do not recommend that investors venture further in terms of maturity, as they will be exposed to significant duration risk. Just look at how interest rate speculation has affected bond funds over the past two weeks. Given the continued strength in the economy, investors could benefit from a slight decline in the credit curve. BSV is probably the safest, or nearly so, short-term bond ETF, the premium offered to investors willing to look down the yield curve is significant in an inflationary environment.
The iShares 0-5 Year High Yield Corp Bond ETF (SHYG) is a viable alternative for investors comfortable with high yield credit. Vanguard doesn’t offer high-yield credit-exposed funds, so the BlackRock product should satisfy us for now. The fund has a similar maturity mandate of less than five years and focuses entirely on lower quality issuers. Many of these issuers remain in the upper tier of high yield credit ratings.
SHYG offers a TTM yield of 4.86% which significantly exceeds BSV and brings investors closer to the rate of inflation. With inflation expected to subside over time, SHYG can offer shareholders a return that can match. Although the fund is inevitably more volatile, it has been able to outperform BSV over time without too much additional price movement.
Regardless, investors should always note that high yield fixed income securities are inherently riskier than investment grade securities and Treasuries. Although fixed income securities have remained stable overall with remarkably low default rates, investors should consider the risks.
BSV is a simple fund that has been delivering shareholder value for over a decade. Vanguard is one of the largest asset managers in the world and BSV is a major fund with nearly $12 billion in assets. We failed to mention the expense ratio of five basis points, one of the lowest available. The fund provided a reliable core portfolio for income-oriented investors. The portfolio is safe with assets invested in high quality fixed income securities issued by the US Treasury and high quality corporations.
Bonds deserve a place in every portfolio. Their consistency provides a moat of stability in times of volatility and their interest income can offer comparatively attractive returns. That said, it’s hard to get excited about BSV with a TTM yield of 1.45%. BSV will survive and, in the longer term, may even thrive. At this stage, we are neutral. If you are a shareholder in desperate need of a short-term bond fund, BSV is one of the best available.