Vanguard Long-Term Bond ETF (BLV): Time To Start Accumulating

ETF Overview

The Vanguard Long-Term Bond ETF (NYSEARCA:BLV) focuses on long-term investment grade bonds in the United States. Given that we are likely near the end of this rate hike cycle, we think the bond offers a good attractive entry point, especially because long-term bonds are rate sensitive. As inflation continues to fall, we see treasury rates move lower. This should result in higher bond prices. Bonds in BLV’s portfolio will benefit from this trend.

Fund Analysis

Underperformance in 2022, but will this repeat again in 2023?

Like many other bond funds, 2022 was a brutal year for BLV. In fact, BLV’s fund price has declined by nearly 30% last year. Even when including the interests earned, the bond’s performance was a decline of nearly 27%. This poor performance was primarily due to the Federal Reserve’s aggressive rate hike to combat inflation. This was because bond prices have an inverse relationship to interest rates.

BLV’s performance was quite poor compared to other bond funds that have shorter-term duration. As can be seen from the chart below, BLV’s peer Vanguard Short-Term Bond ETF (BSV) has delivered a total return of negative 5.5%. This was better than BLV’s total return of nearly negative 27%. This underperformance was primarily due to the longer-term duration bonds that BLV has in its portfolio. In fact, the fund owns bonds with an average duration of 14.3 years.

The question many people have is whether this scenario will repeat again in 2023. The short answer is unlikely. Here is the reason why we believe the scenario in 2022 will not be likely to repeat again in 2023. It appears that inflation has already peaked. As can be seen from the chart below, inflation rate has gradually been in a declining trend since it reached the peak of 9.1%. Therefore, the Federal Reserve does not have a strong motive to aggressively hike its interest rate as it did last year. The most recent hike of only 25 basis points was a sign that we are likely near the end of this rate hike cycle. The Federal Reserve may want to soon pause and observe the impact of the aggressive rate hikes that it had done in the past year has on the economy before deciding what to do next. Therefore, we do not think a decline of such a greater magnitude will repeat in 2023 unless inflation shoots up again.

US inflation rate

Low credit risk but doesn’t mean there is no risk

BLV’s portfolio of investment grade bonds consists of both U.S. treasuries and corporate bonds. As the table below shows, U.S. treasuries represent about 45.2% of the total portfolio. The rest are corporate bonds with investment grade ratings. Investment grade bonds have a low default rates than non-investment grade 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, non-investment grade bonds have a much higher default rate. For example, during the time of the Great Recession, non-investment grade bonds reached a default rate of 14%.

We are not concerned about bonds with AAA, AA, or A ratings in BLV’s portfolio. However, the only concern we have is the BBB bonds that BLV owns. Presently, about 26.5% of BLV’s portfolio consists of BBB bonds. BBB bonds are the lowest grade investment bonds. If the economy is heading for a recession, some of these bonds with BBB ratings may be downgraded and hence will result in a valuation correction. In such scenario, BLV’s fund price will be impacted negatively.

Should you own BLV in 2023?

Besides being attracted by its yield of 4.9%, whether you should own BLV or not depends on your view on the economy in 2023. We are in the camp that the Federal Reserve will likely stop raising rates in 2023. Perhaps, the Federal Reserve will hike 25 basis points each in the upcoming few meetings, but likely will stop after that. The thing to keep in mind is that the Federal Reserve will likely not lower its rate in 2023 due to a strong job market report, as January’s unemployment rate of 3.4% is the lowest we have seen in decades. To reach the Federal Reserve’s long-term target of 2% inflation rate, unemployment rate will inevitably need to move higher. It appears that there is still a long way to go. Hence, we do not think the Federal Reserve will keep the rate elevated for a while and not be in a hurry to drop its rate in 2023. Therefore, investors of BLV should be prepared to own BLV in the long term. As inflation gradually moves down in 2023 and 2024, we do see the potential of capital appreciation.

Risks

We see two risks of owning BLV. First, as mentioned earlier, about 26.5% of its total portfolio consists of BBB bonds. In an economic recession, some of these bonds may be downgraded to non-investment grade bonds. This will result in a price decline. Since 2023 is going to be an uncertain year, we think owning bond funds with solely U.S. treasuries may provide better protection.

Second, while inflation is falling, it may still come back again as we do have a strong job market. In addition, the reopening of the economy in China may result in a demand and supply imbalance and result in global inflation. If inflation comes back again in 2023, the Federal Reserve will have no choice but to continue its rate hike cycle. Thus, the terminal rate may be much higher than originally anticipated. BLV’s valuation will be re-rated downward.

Investor Takeaway

BLV is a good choice if you think inflation will continue its downwards trajectory towards the Federal Reserve’s long-term target of 2% and that the economy remains healthy. However, given the uncertainty of the economic environment, investors should be prepared for some downsides in the near term. If you plan to own this for the long term, be prepared to add more shares on any price weaknesses to average out your total cost.