Vanguard Long-Term Bond ETF: What you need to know before you buy

The performance of Vanguard Long Term Bond ETF (BLV -0.75%) it improved ahead of the federal funds rate cut in September. This makes complete sense given the long-term nature of bonds.

But before you rush out to buy this exchange-traded fund (ETF), you should understand both the positives and negatives of owning it. Here’s why you might want to buy this ETF, as well as why you’d rather own a short-term bond ETF.

What does the Vanguard Long-Term Bond ETF do?

Without getting into the nitty-gritty of the investment approach, the Vanguard Long-Term Bond ETF buys long-term investment-grade bonds. This ends up being a mix of US government bonds (about 50% of the portfolio) and corporate bonds rated BBB or higher. The current corporate bond breakdown is 1.4% AAA, 5.7% AA, 20.8% A and 22.7% BBB. Note that Vanguard isn’t specifically trying to avoid the highest-rated bonds (AAA and AA)—there simply aren’t that many bonds that qualify for such high ratings.

Image source: Getty Images.

That said, it’s important to differentiate between what you could do as a bond investor and what a mutual investment vehicle like an ETF needs to do. By mandate, this ETF must hold long-term bonds. Each passing year means that there are new bonds issued and older bonds that have maturities that no longer qualify as long-term or that are simply paid off.

The Vanguard Long-Term Bond ETF needs to update its portfolio so that it continues to represent the long-term bond market it is trying to track. You, as an individual, might buy a long-term bond and simply hold it until maturity. These are very different approaches.

For example, if you buy a long-term bond with a high yield (say, 10%), you would probably never sell it. You’d collect that 10% interest until the bond matured, and you wouldn’t pay much attention to the bond’s market price. But an exchange-traded fund meant to chase long-dated bonds will have to sell it long before that point, once the remaining maturity no longer qualifies as long-dated. This could result in either a profit or a loss on the bond, and then that bond will be replaced by a newer bond that pays interest at the then-current rate.

Simply put, the cash you collect in dividends from the Vanguard Long-Term Bond ETF will fluctuate over time, and so will the value of the ETF. This is a risk with any bond ETF that is not structured to buy and hold until maturity (there are some that do just that).

Long-term bonds are riskier than you might think

This is where the story gets more interesting, as long-term bonds tend to be much more sensitive to interest rate changes than shorter-term bonds. That’s just the nature of long-term bonds. But it does mean that price swings in the Vanguard Long-Term Bond ETF can be much more dramatic than some investors might be led to believe.

BLV data by YCharts

The chart shows how dramatic the swings can be. Notice the orange line, which represents price performance Vanguard Short-Term Bond ETF (BSV -0.20%). It has remained almost stable over the past decade. This is because the interest paid on short-term bonds resets more quickly when interest rates change.

But the price of the Vanguard Long-Term Bond ETF (purple line) rose and fell much more dramatically as interest rates (blue line) changed. This is normal. If you can’t handle that kind of volatility, you probably shouldn’t be holding long-term bonds.

How much are you paid?

The problem is that short-term bonds generally have lower interest rates than long-term bonds. So the Vanguard Short-Term Bond ETF has a 3% return versus a nearly 4.3% return on the Vanguard Long-Term Bond ETF. On an absolute basis, that’s not a huge difference, but percentage-wise, it’s about 40% more revenue.

This is significant and helps explain why some investors may be attracted to the long-term bond space. However, if you are a conservative investor, the increased risk of holding a long-term bond ETF may not be worth it for you.

This is especially important to note today as the Federal Reserve appears to be headed for lower interest rates. What this means for investors is that long-term bond ETFs like the Vanguard Long-Term Bond ETF will outperform as rates fall. But don’t forget the other side of the equation, because those same ETFs will underperform when rates rise again. If you want a set-it-and-forget-it portfolio, the Vanguard Short-Term Bond ETF will likely be a better option over the long term.