BLV: It’s Time to Update Vanguard’s Long-Duration Fund

It’s been over two years since we last discussed the Vanguard Long-Term Bond Index ETF (NYSEARCA: BLV). In fact, the last time we talked about this particular fund was in January 2022. Given the extraordinary macroeconomic changes since then, it’s time to revisit one of the largest long-dated bond funds.

Beginning with our previous coverage, the pandemic has recently died down and the Federal Reserve has kicked off the rate-cutting cycle, cutting the federal funds rate to zero in a bold effort to revitalize a battered economy. As often happens, an unprecedented situation precipitated unprecedented action by the federal government. After rates bottomed out, I presented a thesis that bonds had no room to run. The mainstay of the thesis was that interest rates had to rise for bonds to become attractive. However, it should be so In this case, BLV’s net asset value would be negatively affected.

Today, we revisit BLV and explain the critical differences between two years ago and today.

Fund overview

BLV is an exchange traded fund managed by Vanguard. BLV invests in long-term bonds according to the Bloomberg US Long Gov/Credit Float Adjusted Index. The index includes government bonds and corporate bonds rated BBB- or higher by S&P. Our initial coverage of BLV provided a more comprehensive overview of BLV’s portfolio and long-term performance history. Today, we will discuss the recent changes and prospects for improvement of the fund.

BLV lands at the longest end of the duration curve at 13.7 years, meaning that BLV is sensitive to interest rate movements. BLV is one of the longest-duration exchange-traded funds, similar to the iShares 20+ Treasury Bond ETF (TLT) that focuses exclusively on long-duration Treasuries. The fund is large, holding more than 3,000 individual bonds with an average yield to maturity, or YTM, of 5.0% and a weighted average maturity of 22.5 years. The average coupon is 3.9%. The difference between the average YTM and the average coupon indicates the impact of rising interest rates on long-term bonds. Most holdings in the portfolio continue to trade at a significant discount to face value despite being well-quoted.

Almost half of the assets are invested in US Government Treasuries. The rest of the portfolio is invested in corporate bonds rated BBB- or higher. The rest of the portfolio’s credit quality is downgraded from AAA (1.4%) to AA (5.6%) to A (21.3%) to BBB (22.3%). There are far more A and BBB rated companies than AAA and AA, which explains the index’s greater concentration toward the lower end of the investment grade spectrum.

BLV is also one of the cheapest exchange traded funds. Vanguard funds are notoriously cheap, consistently outperforming competing asset managers. BLV charges just four basis points, compared to an industry average of 83 basis points, according to Vanguard.

Performance update

We last covered BLV in January 2022. We assigned a “Hold” rating, highlighting key risk factors for BLV with a focus on interest rate risk. Specifically, I presented the idea that a rising federal funds rate could lead to a significant decline in stock prices based on the duration of the fund.

In our original coverage, we provided a historical analysis of previous rate hike cycles, assessing the damage to BLV’s net asset value. I said:

The problem for BLV is that interest rates are at record lows and are expected to rise sooner rather than later. With predictable risk associated with interest rates for BLV, shareholders should be sensitive to these rate increases. As an important benchmark, let’s look at how BLV fared in a previous period of rising rates. Between 2017 and 2018, the federal funds rate rose from near-zero rates during the Great Financial Crisis. The target rate range increased from 0.00%-0.25% to 2.25%-2.50% during that period, the most substantial interest rate increase since before the Great Financial Crisis.

As shown above, performance during both rate hike cycles deteriorated faster and more significantly than Vanguard’s short- and medium-term funds. BLV is a long-duration fund, which means it invests in bonds that are more sensitive to changes in interest rates. When rates rise, the value of these bonds falls more significantly than short or intermediate bonds.

Since our last coverage, BLV’s share price has fallen nearly 30%, marking one of the biggest pullbacks in the fund’s history. When rates were low, BLV stock was trading above $100, and today the price has been reduced below $75. Interest rates are the culprit behind this significant change.

If we consider the distributions paid during this time frame, the performance improves slightly, but remains negative for a period of more than three years. If the dividends were reinvested, the total return for BLV is still -20%. BLV and similar funds will be used as a case study to show the dramatic effects of rising interest rates on bonds and bond funds. Additionally, the decline in the share price has boosted BLV’s yield to its highest in about a decade.

The picture painted above is positively terrifying. Based on discounts from peak share prices, it would take nearly ten years for the fund’s dividends to offset the recent NAV erosion. Not only has the picture changed, but it looks almost upside down compared to the last two years.

What Has Changed?

Simply put, bond performance is a more predictable game than stocks or real estate. There are fewer variables that go into the valuation and performance of government bonds than other more complex investments. This means stability and is why bonds have remained a foundation of portfolios for decades.

Bond ratings are a dynamic variety of contributing factors, including the economic outlook, the federal funds rate, forecasts of changes in borrowing costs and time to maturity. Bond prices generally follow movements in the federal funds rate and the ten-year Treasury yield, assuming the issuer maintains its creditworthiness. The difference between the bond’s yield and the government’s baseline is the “spread.”

Starting in 2022, the Federal Reserve raised the federal funds rate to an unprecedented rate, causing a similar increase in the ten-year Treasury yield. Rising yields rippled across the economy, causing deep shifts in fixed income, real estate and a variety of other assets as markets began to quickly adjust to a new future.

Over the past few decades, bond yields have seen a steep decline. As ten-year Treasuries have fallen over generations, corporate bond yields have followed. Coupon rates fell until they finally bottomed out in the wake of the pandemic. See our commentary that BLV’s average coupon is just 3.9% despite holding bonds with maturities of over 20 years.

According to data from St. Louis FRED, the spot rate on 20-year corporate bonds has fallen more or less continuously since its peak in the 1980s. Over four decades, long-term corporate bond yields have fallen to below 2% in 2021. The extraordinarily low yield meant there was nowhere to go but up. The past two years have erased roughly 20 years of declining returns, explaining the significant impact on BLV’s net asset value.

The question becomes where interest rates might go from here. Without a crystal ball, following the Federal Reserve is probably our best bet. At this point, the likelihood of a short-term rate cut appears high. The Federal Reserve has changed its tone, deviating from their dovish approach to interest rates.

According to the market, rate cuts are almost certain by the end of the year. Markets have started to forecast cuts at the September meeting as comments begin to take shape around the possibility of lower borrowing costs. Mary Daly, president of the San Francisco Federal Reserve, recently advocated a gradual rate-cutting cycle over the next few years. Other sources corroborate the likelihood of a multi-year rate cut cycle.

CME FedWatch is a frequently cited tool that provides forecasts of changes in the federal funds rate. The instrument forecasts a short-term rate cut and corroborates the possibility of a longer-term rate cut cycle. Twelve months out, the tool estimates that the range for the federal funds rate is most likely to be 3.25% – 3.50%.

Falling rates would precipitate the opposite impact of rising interest rates. As interest rates fall, the value of existing bonds rises. For long-dated bonds like those held by BLV, the impact is more significant and the value of BLV’s portfolio could increase. If ever there was a long time, it might be now.

Conclusion

I first covered BLV when interest rates had hit a long-term trough. After four decades of almost uninterrupted decline, interest rates have reversed. Share prices have fallen by almost a third since our initial coverage, following our pessimistic interest rate outlook. outside.

Today, the federal funds rate remains the highest it has been in decades as the Federal Reserve continues to struggle with a struggling economy. Put simply, the worst is in the rearview mirror for BLV. Today, the fund has a completely different outlook, which earned BLV an upgrade to a “Buy” rating. The fund’s indexed approach and low expense ratio mean it can be a core holding in a fixed income portfolio. For those looking to play the duration curve as the Federal Reserve begins to shift, BLV is one of the longest-duration funds in Vanguard’s lineup. The duration of the fund means that falling interest rates could lead to double-digit price appreciation for BLV.

Those looking for a core bond fund can choose another option from the Vanguard lineup, such as the Vanguard Total Bond Market Index Fund (BND) ETF, which covers all maturities and has a shorter duration. However you choose to go ahead, bonds have the brightest outlook in decades.