An Opportune Moment to Begin Accumulating the Vanguard Long-Term Bond ETF(BLV)

Vanguard Long-Term Bond ETF(BLV) Overview

The Vanguard Long-Term Bond ETF (NYSEARCA:BLV) specializes in investing in long-term, high-quality bonds in the US. With indications that the current cycle of rate hikes is approaching its conclusion, we believe that BLV presents an attractive entry point, particularly as long-term bonds are especially sensitive to changes in interest rates. As inflation rates are projected to decline, we anticipate a corresponding decrease in Treasury rates, leading to an increase in bond prices. Bonds held within BLV’s portfolio are expected to benefit from this trend.

The Vanguard Long-Term Bond ETF provides exposure to both long-duration treasuries and corporate bonds. It tracks the performance of the Bloomberg U.S. Long Government/Credit Float Adjusted Index (“Index”), an index designed to measure the performance of U.S. government, investment grade (“IG”) corporate, and IG international dollar-denominated bonds with maturity greater than 10 years.

Vanguard Long-Term Bond ETF(BLV) Analysis

In line with many other bond funds, BLV faced significant challenges in 2022, experiencing a sharp decline of almost 30% in its fund price over the year. Even after accounting for interest earned, the bond’s performance suffered a decline of nearly 27%. This suboptimal performance can be attributed primarily to the Federal Reserve’s aggressive rate hikes aimed at controlling inflation, as bond prices tend to have an inverse relationship with interest rates.

In comparison to other bond funds with shorter-term duration, BLV’s performance was notably poorer. As the chart below illustrates, Vanguard Short-Term Bond ETF (BSV), a peer fund, posted a total return of negative 5.5%, surpassing BLV’s total return of almost negative 27%. This underperformance can largely be attributed to BLV’s portfolio, which includes bonds with an average duration of 14.3 years, which is relatively long-term.

Many are wondering if the events of 2022 will repeat themselves in 2023. Our analysis suggests that this is unlikely. The reason we believe the scenario of 2022 will not reoccur in 2023 is that inflation appears to have already peaked. As demonstrated in the chart below, inflation rates have gradually decreased since peaking at 9.1%. Consequently, the Federal Reserve may not feel compelled to pursue aggressive interest rate hikes as it did last year. The latest hike of only 25 basis points is an indication that the current rate hike cycle may be coming to a close. Before making any further decisions, the Federal Reserve may want to pause and observe the economic impact of the aggressive rate hikes from the past year. Therefore, we believe that it is improbable that we will see such a significant decline in 2023, unless inflation rates surge once more.

The Vanguard Long-Term Bond ETF (BLV) invests in a diversified portfolio of investment grade bonds including U.S. treasuries and corporate bonds. As shown in the table below, U.S. treasuries make up 45.2% of the total portfolio, with the rest being corporate bonds that have investment grade ratings. Investment grade bonds have a historically lower default rate than non-investment grade bonds, averaging around 0.10% per year over a 32-year period.

However, the default rate for non-investment grade bonds can be much higher, reaching 14% during the Great Recession. Our only concern for BLV’s portfolio is its BBB bonds, which account for about 26.5% of the portfolio. BBB bonds are the lowest grade investment bonds, and if the economy heads towards a recession, some of these bonds may be downgraded, resulting in a valuation correction that could negatively impact BLV’s fund price. Nonetheless, we are not concerned about bonds with AAA, AA, or A ratings in the portfolio.

Is it advisable to include BLV in your investment portfolio for 2023?

In addition to its attractive yield of 4.9%, the decision to invest in BLV in 2023 depends on your economic outlook. Our analysis suggests that the Federal Reserve is likely to halt rate hikes in 2023, possibly after a couple of 25 basis point increases in the coming meetings. The January unemployment rate, the lowest in decades at 3.4%, makes it unlikely that the Federal Reserve will lower its rate in 2023.

The unemployment rate will need to increase to achieve the long-term target of 2% inflation rate. Therefore, we believe that the Federal Reserve will maintain elevated rates for the foreseeable future but will not be in a hurry to lower its rate in 2023. BLV investors should plan to hold the investment for the long term. We anticipate potential capital appreciation as inflation gradually declines in 2023 and 2024.

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.

Risks

There are two risks to consider when owning BLV. First, approximately 26.5% of its total portfolio consists of BBB bonds, which may be downgraded to non-investment grade bonds in an economic recession. This would result in a decline in the fund’s price. As 2023 is likely to be an uncertain year, owning bond funds with solely U.S. treasuries may provide better protection.

Second, although inflation is declining, it may rise again due to a strong job market and the reopening of the Chinese economy, causing a demand and supply imbalance that results in global inflation. If inflation rises again in 2023, the Federal Reserve will have no choice but to continue its rate hike cycle, resulting in a terminal rate that is higher than originally anticipated, and BLV’s valuation will be re-rated downward.