VGSH: We’d Rather Own Long-Term Treasury Bonds Now (VGSH)

Introduction

When we wrote our previous article on Vanguard Short-Term Treasury ETF (NASDAQ:VGSH) back in 2020, it was during the midst of a global pandemic. At that time, the Federal Reserve was primarily concerned about a possible lengthy recession, and flooded the market with lots of liquidity. Hence, the Federal Fund Rate was near 0% in 2020. However, with the reopening of the economy and the war in Ukraine in 2022, the concern of the Federal Reserve has shifted towards taming the inflation. Since the macroeconomic picture has shifted dramatically, we have decided it is time to review and analyze VGSH again.

Fund Analysis

VGSH has outperformed other long-term duration bond ETFs in 2022

The bond market has suffered one of the worst years in 2022 due to the Federal Reserve’s effort to raise interest rates to fight against inflation. This is because bond prices have an inverse relationship to interest rates. VGSH is without exception. As can be seen from the chart below, VGSH delivered a total return of negative 2.27% in the past year. Despite delivering a negative return, its performance was better than many other bond ETFs especially those with longer term duration. For example, VGSH’s peer Vanguard Long-Term Treasury ETF (VGLT) has delivered a much worse total return of negative 19.91% in the past year.

Since VGSH’s portfolio consists of short-term bonds (the average year to maturity is about 2 years), the fund is less sensitive to the change of interest rates. This is because they only have a few years left before maturing. Therefore, in a rapidly rising interest rate environment such as the case in 2022, the magnitude of the decline of short-term bond’s price is much less than long-term bonds. Therefore, VGSH’s bond prices have only suffered a minor decline compared to its peer VGLT.

You should own investment grade bonds in 2023

We like VGSH’s portfolio that consists of solely U.S. treasuries. This is especially important when we consider the macroeconomic environment in 2023. The reason why U.S. treasuries are good to own right now is that there may be a possible recession coming up in 2023. In a recessionary environment, the best bonds to own are investment grade bonds as the default rates are way lower than non-investment grade bonds. Since VGSH’s portfolio consists of entirely U.S. treasuries, they will be safe to own and even better than investment grade corporate bonds.

The yield of 4.5% is very sweet

The Federal Reserve has repeatedly stated that they will not be lowering interest rate in 2023. Therefore, interest rate are likely going to stay at this level or a little bit higher from the present level. In this environment, VGSH’s yield of 4.5% appears to be very attractive. In fact, this yield of 4.5% is at a level we have not seen since 2007.

Should you own VGSH right now?

Whether you should invest in VGSH or not depends on your primary investment objective. If your goal is for safety and not total return, this fund will be a good choice. Even if the Federal Reserve raises rates dramatically again in the future, the decline in its fund price will still be manageable compare to other long-term bond funds. This scenario is unlikely given the fact that we are likely already passed the peak of the inflation. Investors who own VGSH can also earn some bond interests along the way. Right now, this interest rate is at around 4.5%.

If you are like us who are primarily interested in a good yield plus excess capital appreciation, VGSH may not be the best bond ETF to own right now. Since we are likely already near the end of the rate increase cycle, the Federal Reserve may start to lower its interest rate eventually, especially if inflation drops further or an economic recession comes about. In such case, long-term investment grade bonds such as VGLT may be a better choice as prices of long-term bonds are more sensitive to the interest rate. When interest rates start to drop, prices of long-term bonds prices should go up. Therefore, VGLT or other similar bond funds will likely accumulate higher returns.

Investor Takeaway

If your goal is to seek safety and earn a good 4.5% interest rate right now, VGSH maybe right for you. However, we are in the camp of seeking higher total return in the future (interests + capital appreciation). Hence, we prefer owning other bond ETFs now.

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.