The performance of the Vanguard Long-Term Bond ETF (NYSEMKT:BLV) improved ahead of the Federal Reserve’s September federal funds rate cut. This makes perfect sense given the nature of long-term bonds.
But before you rush to buy this exchange-traded fund (ETF), you need to understand both the pros and cons of owning it. Here’s why you should buy this ETF and why you might prefer owning a short-term bond ETF instead.
What does Vanguard Long Term Bond ETF do?
Without getting into the nitty-gritty of its investment approach, the Vanguard Long-Term Bond ETF purchases long-term bonds with investment-grade ratings. The end result will be a mix of U.S. Treasuries (about 50% of the portfolio) and corporate bonds rated BBB or higher. The current breakdown of corporate bonds is 1.4% AAA, 5.7% AA, 20.8% A, and 22.7% BBB. Note that Vanguard is not specifically trying to avoid the highest quality bonds (AAA and AA). There simply aren’t that many bonds that qualify for such a high rating.
A road sign indicating future volatility.
Image source: Getty Images.
That said, it’s important to distinguish between what you should do as a fixed income investor and what a co-investment vehicle such as an ETF should do. By mandate, this ETF must hold long-term bonds. Each year that passes means that new bonds are issued with maturities that no longer qualify as long-term, or older bonds that are simply repaid.
The Vanguard Long-Term Bond ETF requires portfolio updates to remain representative of the long-term bond market it seeks to track. As an individual, you may purchase a long-term bond and 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 probably won’t sell it. It will collect 10% interest until the bond matures and will not pay much attention to the market price of the bond. But exchange-traded funds (ETFs) meant to track long-term bonds need to be sold long before their remaining term qualifies as a long-term bond. As a result, there may be a gain or loss on the bond, which is then replaced by a new bond that provides interest at the then-current interest rate.
Simply put, the cash you collect as dividends from the Vanguard Long-Term Bond ETF will fluctuate over time, and so will the value of the ETF. This is a risk for bond ETFs that aren’t structured to buy and hold to maturity (though some do just that).
Long-term bonds are riskier than you think
This is where the story gets even more interesting. This is because long-term bonds tend to be much more sensitive to changes in interest rates than short-term bonds. This is the very nature of long-term bonds. But that means the Vanguard Long-Term Bond ETF’s price movements can be much more dramatic than some investors would like to allow.
BLV chart
BLV data by YCharts
The graph shows how dramatic the swing is. Notice the orange line. Represents the price performance of the Vanguard Short-Term Bond ETF (NYSEMKT: BSV). It has remained fairly stable for the past 10 years. That’s because the interest paid on short-term bonds resets more quickly when interest rates change.
However, the price of the Vanguard Long-Term Bond ETF (purple line) moves up and down in a much more dramatic manner as interest rates (blue line) change. This is normal. If you can’t stand this kind of volatility, you probably shouldn’t own long-term bonds.
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The problem is that interest rates on short-term bonds are generally lower than on long-term bonds. That means the Vanguard short-term bond ETF has a yield of 3%, while the Vanguard long-term bond ETF has a yield of nearly 4.3%. In absolute terms, it’s not a huge difference, but in percentage terms, it increases your income by about 40%.
This makes sense and helps explain why some investors are drawn to the long-term fixed income space. However, if you are a conservative investor, the increased risk of owning a long-term bond ETF may not be worth it.
This is especially important to remember today, when the Federal Reserve appears set on lowering interest rates. What this means for investors is that long-term bond ETFs, such as the Vanguard Long-Term Bond ETF, will perform outstandingly as interest rates decline. But don’t forget the other side of the equation, as the same ETF will perform worse if interest rates rise again. If you want a “set it and forget it” portfolio, the Vanguard Short-Term Bond ETF is probably a better long-term option.
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Reuben Greg Brewer has no position in any stocks mentioned. The Motley Fool has positions in and recommends Vanguard Bond Index Fund and Vanguard Short-Term Bond ETF. The Motley Fool has a disclosure policy.