Main Thesis and Background
The purpose of this article is to evaluate the Vanguard Long-Term Bond ETF (NYSEARCA:BLV) as an investment option. This ETF has a primary objective “to track the performance of the Bloomberg Barclays U.S. Long Government/Credit Float Adjusted Index”. Currently, the fund trades at $111.86/share and pays monthly distributions, with a 30-day yield of 2.9%. This is my first review of BLV and has come about as I look to find appropriate equity hedges for what I expect to be a volatile few months going into 2021. BLV has caught my eye, as it offers monthly income, holds investment-grade debt, and has recently seen some selling pressure. In fact, over the past three months, while large-cap equities have climbed, BLV has seen a negative return around 2%. Further, it has underperformed a diversified bond market fund, the iShares Core U.S. Aggregate Bond ETF (NYSEARCA:AGG), as shown below:
Given this performance divergence, I figured it was an opportune time to take a look at BLV, and see if this sell-off offers a value opportunity, or is more akin to a trying to catch a falling knife. After review, I believe there is some merit to holding on to long-term bonds right now, especially for investors concerned about equity volatility (as I am). However, there are certainly risks present with this strategy, which is why I believe a “neutral” outlook on this fund makes the most sense. This was my conclusion after weighing the downside risk with the upside potential, which I see as likely in the low single digits, and I will explain why in detail below.
Why Have Long-Term Bonds Sold Off? Rising Inflation Expectations
To begin, I want to take a look at the driving force behind the recent weakness in BLV and long-term bonds as a whole. While 2020 overall has been a pretty good year for most fixed-income products, longer-term maturities have started seeing some selling pressure, as investors have begun to expect higher inflation in the near future. The is primarily the result of two factors – continued spending by Congress and the Fed (resulting in larger budget deficits) and stronger economic growth coming out of the pandemic. While both of these developments could be read as good news for investors, they are not positive for long-term bonds because inflation eats away at fixed-income returns. As inflation rises, the yield earned from a fund like BLV is worth less, in real terms. Since long-term bonds tie up money for longer, the impact of inflation is more profound on those investments. Furthermore, investors are beginning to expect higher interests will follow rising inflation, as the Fed will no longer have as much of an incentive to keep rates near 0%.
The takeaway here is that, as inflation and interest rate expectations rose, BLV saw its share price drop. While the fund is fairly stable over time, the recent decline has been driven by a yield curve that has gotten noticeably steeper in the past two months, as shown below:
Source: Charles Schwab
As you can see, spreads between shorter-term and longer-term bonds have widened considerably, so this development is significant. This explains why BLV has lost about $6/share since early August. Longer-term bonds have seen their yields spike as prices declined to account for updated expectations regarding interest rates and inflation.
To understand why this impacts BLV the way it does, let us consider the fund’s duration. This is a measure of interest rate sensitivity, the higher duration, and the more sensitive a bond or fund is to interest rate movements. Given the long-term nature of BLV, it is not surprising the fund has a high duration of over 16 years, as shown below:
This reality exposes just how sensitive to economic conditions, inflation metrics, and interest rate expectations BLV is. For comparison, consider the aggregate bond fund I mentioned earlier, AGG, which represents as a collection of investment-grade bonds across all maturities, has a duration just under six years. The point to emphasize here is BLV is very exposed to interest rate risk, much more so than a broad/aggregate bond fund. Therefore, while I will discuss a few reasons why I think this could be a valid option going forward, investors should recognize there is plenty of risk that comes with this fund. While I believe inflation expectations are getting too aggressive, I could be wrong, and that would result in considerable pain for investors in BLV.
Why Buy Long-Term Bonds? An Equity Hedge
Now that I have discussed the reasons for the current downtrend and the potential risks, I will turn to a few reasons why investors would want to consider BLV. Of course, a primary reason would be income, as BLV pays a monthly distribution that is yielding well above short-term instruments right now. But a second, perhaps even more important reason, is to hedge against volatility and downturns in equities. In fairness, investors have multiple options when considering equity hedges. Most bond sectors have a very low correlation to equities, except for high-yield corporates and preferreds (which are a hybrid of a stock and a bond). However, when we consider bond sectors that have negative correlations with equities, which means they rise when equities fall, there are not many to choose from. In fact, over a five-year period, only long-term Treasuries and broad Treasury indexes have a negative correlation to the S&P 500, within the bond universe, as shown below:
Source: Charles Schwab
This is an important point to emphasize. While most of the options listed in that graphic, such as investment-grade corporates, municipals, and aggregate bond funds, are all valid hedges, we can see the correlation with the S&P 500 is still positive. For long-term Treasuries, by contrast, the five-year average shows they are negatively correlated, meaning investors should expect their prices to rise when stocks drop. The relevance to BLV is that the fund has almost 41% exposure to this asset class, as shown below:
My point here is this is an appropriate investment for those worried about an equity correction, and who want to protect themselves with an investment that could do well during troubled times. If one expects equities to continue rising, economic growth to beat forecasts, and higher interest rates in 2021, then this ETF would not fit in well with those projections. But for someone interested in a way to earn a positive return when equities fall, BLV could fit the bill.
Equities Keep Rising, So Why Do We Need To Hedge?
As I alluded to in the preceding paragraph, investments like BLV are primarily useful when things get rocky. However, the market has been rising steadily over the past six months, with some minor blips along the way. Therefore, it is fair to question the usefulness of this option right now. After all, if stocks keep rising as they have been, BLV won’t offer much of a return, and the opportunity cost of not buying riskier assets could be substantial. While this is true, I personally believe we are going to see some volatility over the next few months, and I am especially concerned because the market no longer seems to be pricing in that possibility. As a result, the downside potential to equities over Q4 is larger now, in my opinion, than it has been for a while.
To understand why, let us consider how investors were predicting election-induced volatility not too long ago, and how things have changed since then. Roughly six weeks ago, at the end of August, prices to hedge against election risk soared, as investors expected quite a bit of turmoil leading up to November 3rd and in the weeks that followed:
As you can see, the risk premium spiked, largely being driven by the expectation we might see a contested presidential election. However, now that Democratic nominee Biden has been rising in the polls, markets have gotten more complacent. They are no longer expecting a long, drawn-out fight over the election results, and they expect markets to be relatively calm through the election and in mid-November.
To illustrate, let us consider the equity put/call ratio, which is often used as a measure of investor sentiment. What this metric does is show put volume relative to call volume. When the figure is above 1, there are more puts than calls, indicating bearish sentiment in the market, and vice versa. Looking back over the past few months, we see the put/call ratio for equities spiked higher in August, when election volatility was heavily expected, and has since dropped to a more normalized lower level:
Essentially, we can read this as investors being very complacent at the moment. The market does not seem to be worried about a short-term sell-off, which means sentiment has changed quite a bit over the past two months.
Of course, investors might be saying “this is good news, so why not buy equities if they are going up?”. The point to emphasize is these are expectations, and the complacency is making me put my contrarian hat on. When expected volatility is low, and put/call ratio hits the low end of its range (as it is now), this suggests to me that further upside is limited. This is no way guarantees stocks will go down, but it does tell me I should start to get careful with my positioning, as markets tend to do the opposite of what we expect. If this complacency does turn out to be misguided, investors will be thankful to have some exposure to long-term bonds through BLV.
The market has been surprisingly resilient despite an ongoing pandemic, continued partial state lockdowns, and a potentially volatile U.S. presidential election. As a result, the risk-on trade has been rewarded, while investors in long-term bonds have seen a negative return over the past three months. Despite this reality, I believe BLV could be useful as we close out 2020. The largest sector within the fund, long-dated Treasuries, has a negative correlation to equities, which could prove useful if the next few months do not go smoothly. While election volatility is being written off, that is not the only event that could cause an equity correction. We could also see persistent (or rising) unemployment, a “second wave” of Covid-19 cases, or geopolitical issues between China and the U.S. could flare up again. As a result, I would recommend investors who are concerned about the next few months to give BLV a look. While I would manage expectations by saying I would not predict a return greater than 1-3%, even a small positive gain would be helpful if stocks drop, which is the scenario I expect to occur by the end of the year.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.