A well-diversified portfolio offers potential upside returns as well as income and downside protection by balancing equity positions and bonds. In addition to regular income, bonds provide an effective hedge against riskier equity investments. On average, bonds have seen negative returns once every six years, and stocks produce negative returns once every four years. The magnitude of the loss is typically higher with equities. Over time, the volatility of a portfolio is reduced if the bond allocation is maintained. Interest rates have been historically low in recent years, thus investment-grade corporate bonds issued by firms with strong balance sheets have been more attractive to investors than Treasuries have been because they offer higher yields with little additional risk.
Interest rates and bond values move as economic expectations change. The current trend indicates that there will be higher yields, which is positive for long-term investors. The Federal Reserve has made it clear that the central bank plans to normalize rates. The recent election resulted in a change in political power that can cause market uncertainty as investors try to figure out the effect on future economic activity, including the growth of the economy, which will affect future Fed policy decisions. Currently, investors are anticipating that the Fed will follow through with its projected gradual increase in rates as policies advocated by the new administration lead to a stronger economy. While this should translate into lower volatility in the bond market, prices may still fall as rates increase, meaning investors must be more selective in their bond choices.
In a rising interest rate environment, investors should shorten durations to mitigate interest rate risk. Selecting bonds can be difficult, and the associated fees may negate any gains. Investing in an exchange-traded fund (ETF), such as the Vanguard Short-Term Corporate Bond ETF (VCSH), should deliver a solid yield and lower interest rate risk, at a low cost.
Launched in late 2009, VCSH draws from a pool of more than 2,000 different short-term corporate investment-grade bonds. The ETF boasts a low expense ratio and tracks the Barclays U.S. 1-5 Year Corporate Bond Index to provide current income with minimal price fluctuation. Approximately 80 percent of the fund’s $15.8 billion in assets under management (AUM) are invested in components of the index. Although corporate bonds carry more credit and quality risk than do Treasuries, domestic firms have significantly fortified their balance sheets in recent years and carry ample on-hand cash balances. An investment-grade company has not defaulted since 2011, and the default rate over the past 30 years is approximately 0.10 percent. Although companies face headwinds including a stronger dollar, profit margins are at a 15-year peak, the economy is growing slowly and overall financial conditions are strong. Consumer spending has increased as confidence reaches multiyear highs and the unemployment rate dips to multi-decade lows. This bodes well for corporate bond issues.
Investment Strategy
VCSH uses a sampling strategy to track the underlying benchmark. Managers select domestic corporate investment-grade bonds with maturities between one and five years that have at least $250 million in value outstanding. The ETF weights the portfolio by market cap and rebalances monthly. The goal is to maintain an average dollar-weighted maturity between one and five years with a target of three years.
The portfolio contains 2,122 individual holdings comprising primarily of debt issued by firms from the financial and industrial sectors, like the underlying benchmark. The holdings consist of an even mix of bonds maturing between one and three years and debt maturing between three and five years. While the average effective maturity is 2.9 years, the average effective duration is 2.75 years. Compared with its category peers, the ETF is overweight AA-, A- and BBB-rated debt. 67.9 percent of the fund’s holdings have coupons ranging from 0 and 4 percent. The fund also has a 23.33 percent exposure to securities with a 4 to 6 percent coupon and a 7.1 percent allocation to debt with a 6 to 8 percent coupon. Less than 2 percent is allocated to bonds carrying a coupon yield greater than 8 percent. The ETF has a 57 percent annual turnover rate. The top 10 holdings make up less than 3 percent of AUM. They include debt issued by Anheuser-Busch InBev, General Electric Co., Capital, Merrill Lynch, JPMorgan Chase, Diamond 1 Financial and Bank of America.
The ETF has above-average return and risk ratings from Morningstar. VCSH has delivered one-, three- and five-year returns of 2.63, 1.92 and 2.49 percent, respectively. The category averages over the same periods were 2.01, 1.09 and 1.45 percent. The ETF has an SEC 30-day yield of 2.28 percent. The fund’s three-year beta and standard deviations are 0.35 and 1.54, respectively. These compare with the category averages of 0.28 and 1.28. The fund has an expense ratio of 0.07 percent, which is lower than that of most of its competitors.
Recommendation
VCSH is suitable for investors looking for an established short-term corporate bond ETF that boasts low trading and holding costs. The ETF helps individuals maintain the fixed-income portion of a well-diversified portfolio while mitigating interest rate risks. This ETF is available as an open-end mutual fund. With a 0.10 percent expense ratio, the Admiral class shares (VSCSX) require a $10,000 minimum initial investment. Trading under the ticker symbol VSTBX, institutional class shares have a 0.07 percent expense ratio and a $5 million investment minimum. Currently, we have issued a Strong Buy recommendation with a ranking of 90. While the returns of the fund are modest, it serves an important role in nearly every portfolio.
Alternative Investments
The closest direct competitor to VSCH is the SPDR Barclays Short Term Corporate Bond ETF (SCPB). With approximately $4 million in AUM, the ETF has a much smaller asset base. While exclusively investing in corporate bonds like the Vanguard fund, SCPB caps maturities at three years rather than five. Limiting maturity has reduced the fund’s volatility, but it has also reduced its overall returns when compared with VSCH.
Another option is Vanguard’s Short-Term Bond Fund (VBISX). This strong competitor maintains a broader, more diversified exposure to the short-term bond market by also investing in government securities. With a 0.16 percent expense ratio, the fund tracks the Bloomberg Barclays U.S. 1-5 Year Government/Credit Float Adjusted Index. The fund is also available as an ETF trading under the symbol BSV.