Vanguard’s ETF BIV might lose value in tightening environments

Thesis

Vanguard Intermediate Term Bond ETF (NYSEARCA:BIV) is a fund that seeks to track the performance of the Bloomberg U.S. 5-10 year Government/Credit Float Adjusted Index. The ETF gives you a balanced exposure to the intermediate term, investment-grade U.S. bonds market. There is a 50/50 split between government bonds and investment grade bonds. The fund’s trailing total returns are approximately 3% over the 3-, 5-, and 10-year periods. This is achieved with a low standard deviation (3.33) and a Sharpe ratio (0.57) both measured on a 5-year basis. The fund’s principal risk is the impact of interest rates movements, but its credit risk profile is well mitigated by its granular structure. The fund has a duration of 6.6 years. This will impact its NAV performance within the next six month. We expect a retracement from the 2018 tightening cycles, which saw the yield curve rise to 3% with 7-year yields currently at 2%. We expect further weakness from higher rates over the next six months, with a predicted price movement of -5%, as implied by the ETF’s intermediate duration analytics. Although the fund is a solid buy-and-hold long-term vehicle that can be used to hold and invest in Treasuries, it has not been able to outperform its pure Treasuries peer iShares Treasury Bond ETF (IEF), on a 10-year basis. However, it is not likely to escape the current tightening environment. We believe that a retail investor is the best fit. SellBIV now, and revisit in August/September. The tightening move should most likely be priced in the yield curve. NAV’s downside is likely to be minimal going forward.

Holdings

The fund is a mix of investment grade bonds and Treasuries.

The portfolio’s investment-grade bond portion is at the bottom end of the ratings spectrum for this asset class.

We can see that the portfolio’s bond component is tilted towards less-rated credits, such as BBB credits, which account for 23.4%.

The corporate side of the equation shows that the portfolio is overweighted in industrials and financials.

Credit & Market Risks

The main risk to the fund is market risk and, in particular, the duration run interest rate sensitive.

The ETF’s intermediate duration is 6.6 years. This will negatively impact performance as interest rates rise. We can see the duration impact by looking at the Vanguard bond math table.

The ETF falls roughly in the intermediate term bucket. This gives it an additional 5%-6% negative performance if 7 year yields rise by another 1% (i.e. 100 bps).

We can see that the 7-year yields peaked at 3% in their last tightening cycle if we look at their historical performance.

Inflation is at a much higher level in 2018 than it was in 2018. Therefore, we fully expect the 7 year point in the Treasury curve to retrace its performance during the previous tightening cycle. There is also the possibility of yields increasing further. However, a continuous inversion of yield curve shows that the market doesn’t believe the Fed has as much flexibility as it should in such an inflation environment. Therefore, we don’t believe 7-year yield rates will exceed 3%.

The fund has a small credit risk via its corporate bond holdings and in particular its BBB bucket. Credit risk refers to the possibility that an underlying issuer will default. It is measured by its credit rating as well as its credit spread to treasuries. The BBB bucket is indeed quite large. However, the fund is very well-diversified with over 2000 bond holdings (thus a very fine issuer profile). We think that the carry drag (i.e. Impact on fund performance) is very minimal.

Flows

This year, investors have seen a substantial outflow from fixed income.

The market recognizes the weakness of fixed income due to its duration and has voted to leave. We don’t expect flows to be favorable to a positive performance before we have a better understanding of where the yield curve will end up and how determined Fed is to fight inflation, which negatively affects GDP growth.

Continued outflows from fixed income IG credits will negatively impact BIV.

Performance

The fund’s total trailing return is around 3% for a 3- to 5-year, 10-year and 10-year period.

Higher yields have caused the ETF to fall on a year-to date basis.

The ETF has a similar 5-year return profile to the pure Treasuries ETF IShares 7-10 Years Treasury Bond ETF (IEF), whereas the pure corporate product (LQD), displays a more volatile but higher total return profile.

The 10-year chart shows a similar picture. BIV is a solid buy and hold vehicle that provides a nice mix of treasuries as well as investment grade bond portfolio returns.

Conclusion

BIV is an ETF with fixed income that splits 50/50 between investment grade bonds and treasuries. This fund will provide a 3% annual total return over the long-term, as evidenced by its trailing total returns of 3%, 5, and 10 years. The ETF’s principal risk is the yield curve, which can lead to it losing value in an environment of tightening. The intermediate duration of the fund is 6.6 years. It will be vulnerable to further weakness if 7-year yields rise towards the 3% mark. This level was the upper bound during the previous tightening cycle. A Fed that is more aggressive in fighting inflation could push yields higher than the previous cycle. This fund is rated a SellExpect a further -5% movement in the coming months as the market trades the 7 year curve point higher towards the 3% mark.