ETF BLV: interest rate risks galore
The Vanguard Long Term Bond ETF (NYSEARCA: BLV) is an exchange-traded fund that provides investors with access to a large part of the universe of long-term fixed income securities. The fund benefited from strong credit markets and falling interest rates which fueled impressive long-term performance. However, high inflation and rising interest rates will test BLV’s ability to maintain this performance.
Bonds have gained a central place in almost all income-oriented portfolios. Simply put, traditional bonds are one of the safest and most liquid investments available to investors. In the long run, fixed income has proven to be a safe asset class, as corporate default rates have remained low for decades. Default rates across the debt market have remained stable and low, averaging 1.47% over the past 30 years. Investment grade debt has been remarkably secure with an average default rate of just 0.10% per annum. These limited defaults are heavily weighted by non-investment grade securities, which are completely excluded from BLV’s portfolio. As a result, BLV can provide shareholders with reliable security and income in the form of monthly dividends.
BLV offers investors the opportunity to access a substantial portion of the domestic high quality fixed income market. The fund is smaller by Vanguard standards with around $ 11.6 billion in assets under management. Let’s dive into the portfolio and see what BLV has to offer.
BLV is well diversified in terms of issuers and credit rating. With a huge portfolio, BLV was able to spread risk by effectively eliminating the risk of singular bankruptcy. Although the fund is limited to bonds with maturities greater than ten years, the fund still holds around 3,000 individual securities. A large part of this portfolio (43%) is allocated to public debt. The rest of the portfolio is allocated to corporate investment grade debt. The largest under-allocation within corporate credit is rated BBB, followed by A. This weight is influenced by the number of issuers within each credit rating. There are more BBB rated issuers than AAA rated issuers.
The fund aims to provide long-term fixed income exposure, which means bonds maturing in the next ten years are almost completely excluded. As a guide, 0.6% of the portfolio has a maturity of less than ten years and the fund will sell these positions to align with its objectives.
The long-term orientation translates into a weighted average maturity of 23.4 years and an effective maturity of 16.3 years. The duration of the fund presents an enormous level of interest rate risk for investors. If interest rates rise by 100bp, the fund could lose approximately 16% of its net asset value over that period.
The returns within the portfolio are low, especially for the high volatility associated with long term bonds. The portfolio has an average coupon of 3.8% and a yield to maturity of 2.5%. Keep in mind that the returns are suppressed due to the large government allocation. Firms offer a modest spread over risk-free assets.
BLV is simple and effective in what it offers. Investors can access a portfolio of quality and government-issued securities in a scalable, tax efficient and transparent package. With limited default throughout the fund’s history, total return has been strong for BLV. However, shareholders will immediately notice that returns are more volatile than shorter-term funds.
The fund provided reliable income to shareholders without substantial hesitation along the way. Over the past ten years the fund has generated just over 6.00% annual return, mainly through a monthly interest distribution. Since its inception in 2007, BLV has achieved a superior performance profile. Investors should note that BLV has benefited from long-term interest rate declines which have increased the NAV at the expense of the fund’s distribution.
As mentioned, the bulk of BLV’s return is generated by fund distributions. The BLV passes on income that has declined since its inception due to falling interest rates. As interest rates fall, issuers have refinanced the debt at lower rates. While beneficial for issuers who pay less interest, the fund’s dividend suffered considerably. The dividend is steadily declining.
The fund was less stable in its declining distribution than shorter term funds such as the Vanguard Short-Term Bond Fund (BSV).
Supported by falling interest rates and strong credit performance, BLV has historically performed well. BLV has offered reliable income and stable stock prices with some appreciation to be enjoyed along the way. For more than a decade, the fund has shown solid performance. However, we must always recognize that past performance is not a reliable indicator of future returns. To this extent, BLV’s medium-term outlook is not bright. Several factors will almost certainly hamper BLV’s ability to perform in the years to come.
As an index fund, BLV’s performance depends directly on the performance and health of the credit markets. Fortunately for investors, fixed income securities have predictive cues that are useful in detecting incoming risk and volatility.
One of the main pricing factors for fixed income assets is interest rates. The movement of federal interest rates and the price of a bond have an inverse relationship. When interest rates rise, the value of outstanding bonds decreases due to the opportunity cost associated with lower cash flow.
The problem for BLV is that interest rates are at their lowest and should go up sooner rather than later. Having a foreseeable risk associated with interest rates for BLV, shareholders should be sensitive to these rate hikes. As an important benchmark, let’s take a look at how BLV fared in a previous period of rate hikes. Between 2017 and 2018, the federal funds rate increased from near-zero rates in the era of the Great Financial Crisis. The target rate range fell from 0.00% -0.25% to 2.25% -2.50% during this period, the largest increase in interest rates since before the Great Financial Crisis.
Source: New York Fed
Unfortunately, BLV’s overall performance was poor when interest rates started to rise in 2018. The fund suffered from a sharp drop in prices, resulting in a loss for BLV shareholders. Given the circumstances, we knew this was going to happen. Unfortunately, BLV simply had nowhere to hide given its rigid exposure to long-term bonds.
BLV shareholders can look at the circumstances today and see some similarities. At this point, it seems almost inevitable that interest rates will start to rise at some point over the next couple of years. If this happens, BLV’s portfolio could come under pressure not unlike 2018. While the Fed has remained reluctant to raise rates due to its sensitivity to the economy, the pressure is mounting.
These other factors bring us to our next look at the outlook for BLV, which is inflation itself. The United States has just measured an annualized inflation rate of 6.8% in 2021, the highest of the last decade by a frightening margin. With such a substantial rise, asset classes are feeling the pressure to perform as investors seek to outperform rising asset prices.
Source: Inflation data for the United States
Inflation has now become a crucial consideration for investors. Inflation effectively acts as a barrier rate. If investors can’t earn at least the rate of inflation, they aren’t earning a real return on their money. With rates at their lowest, it seems unlikely that a further price comeback is possible.
Interest income is expected to remain stable, but modest during the duration of low interest rates. A silver lining that is worth mentioning is the benefit of the rate hike. When issuers begin to refinance at higher rates, newly issued bonds that fall within BLV’s maturity range will include higher coupons. Increases in coupon rates will result in higher monthly distributions to shareholders. In addition, the distribution could be affected by changes in the yield curve. A relatively flat yield curve resulted in a reduced premium in the distribution of BLV compared to shorter term fixed income funds.
BLV is a simple fund that has provided shareholder value for over a decade. Vanguard is one of the largest asset managers in the world and BLV is a large fund with almost $ 12 billion in assets. We failed to mention the five basis point expense ratio, one of the lowest available. The fund has provided a reliable core portfolio for income investors. The portfolio is secure with assets invested in high quality fixed income securities issued by the US Treasury and investment grade companies.
While the fund offers huge benefits, BLV’s past performance has been fueled by favorable winds which are simply unsustainable. The fund will be exposed when interest rates start to rise, which will put pressure on the performance of equities. Recent declines in stock prices reflect the pressure ahead as the Fed gets serious. While rising interest rates should support increases in payout, overall performance will be offset by the impact of interest rate risk on NAV, negating short-term shareholder benefits. By combining these risks with the current inflation rate, the picture becomes grim as the fund is unlikely to provide any real return.
Bonds deserve a place in every portfolio. Their regularity provides a gap of stability in times of volatility and their interest income can offer attractive comparable returns. That said, it’s hard to get excited about BLV. Even a fifty basis point rate hike will significantly negate the distribution’s performance from a multiple duration perspective. The BLV will survive and, in the longer term, may even thrive. At this point, we are neutral. If you are a shareholder committed to investing in a long-term bond fund, BLV is one of the best available.