Vanguard Intermediate-Term Bond ETF (BIV): Why ETFs Are Good Investments

investment thesis

I believe there are great investment opportunities in the bond market, and the same favorable scenario applies to all ETFs based on bonds. Vanguard Intermediate-Term Bond Index Fund ETF Shares (NYSEARCA:BIV), any Holding investment-grade bond products is an excellent choice for low-risk investors who want to benefit from a stabilizing or falling interest rate environment, as the Federal Reserve has noted.

In the United States, the Federal Reserve (Fed) raised the federal funds rate in response to high inflation and came close to achieving its inflation target rate of 2%. If the Fed meets its target, the federal funds rate will begin to fall, lowering bond yields and causing the price of shares of the Vanguard Intermediate Term Bond Index Fund ETF to rise.

introduction

this article We explain why Vanguard Intermediate-Term Bond Index Fund ETF stocks are a great opportunity. The first part explains the composition of the ETF, followed by the relationship between the shares of the Vanguard Intermediate-Term Bond Index Fund ETF and 10-Year Treasury Notes. The second and most important section examines the underlying data to explain why you should consider this investment vehicle.

first part

ETF composition and sectors

Vanguard Intermediate-Term Bond Index Stock is an ETF that tracks a market-weighted bond index with a maturity of 5 to 10 years. As of February 2023, the average time until maturity is 7.2 years. The ETF consists of 55.58% Treasury bonds, 21.56% BBB-rated bonds, 18.32% A-rated bonds, 2.39% AA-rated bonds, 2.19% AAA-rated bonds, and 0.4% NR-rated bonds.

For those of you unfamiliar with the topic, bonds rated AAA, AA, AA, and BBB are investment bonds. This means that the entity issuing the instrument is in a strong financial position to repay its debt. A 1996 study found that the annual default probability of these bonds was less than 0.1%. On the other hand, U.S. Treasury bonds have a 0% default probability because the government can print money to repay debt as a last resort.

By industry, Vanguard Medium-Term Bond Index Fund ETF Shares are comprised of 56% government bonds, 22% industry, 14% finance, 4% overseas, 3% utilities, and 1% other. It is worth mentioning that the ETF is linked to the US economic system and holds government bonds and bonds from the industrial and financial sectors.

Vanguard Intermediate-Term Bond Index Fund ETF shares (black line) underperformed their benchmark (Bloomberg US 5-10 Year Government/Credit Float Ad Exchange Index) in part due to expense ratios and sampling techniques to replicate the benchmark. . A red flag is the gap between the ETF and the benchmark. A difference of more than 3% occurred in just one year. Currently, ETFs have lower yields than one-year Treasury bonds. The operating ratio is 0.04%, and the average operating ratio of similar funds is 0.57%. Lastly, operating assets are $37.75 billion.

Vanguard Intermediate-Term Bond Index Fund ETF Stocks and 10-Year Treasury Bonds

Before moving on to other sections, it is important to remember that the Vanguard Intermediate-Term Bond Index Fund Shares are ETFs. This means that you will need to rebalance to track Bloomberg US 5-10 Year Government/Credit every certain period. The underlying asset is a liquid-adjusted index. As a result, instruments included in the weighted basket do not remain in the ETF until maturity.

Explaining how the Vanguard Intermediate Term Bond Index Fund gains or loses value is important because it will help us understand how the Federal Reserve’s announcements affect this financial product. Imagine that an investor buys a Treasury bond with a maturity of 5 years and it pays 4% interest each year. Let’s assume two possible scenarios at the same time: One month after purchase, in the first scenario, the government issues a bond with a 5% coupon, and in the second scenario, the government issues a bond with a 3% coupon.

In the first scenario, bondholders would lose money. Because if he had waited a month, he would have earned 1% more interest. There is a difference between earning 5% of $1000 ($50) instead of earning 4% of $1000 ($40). In the second scenario, the investor’s financial position will be better. At a 3% coupon rate, the investor would receive $30, which is $10 less than what he would receive at a 4% coupon rate.

Now it’s time to look at the relationship between Vanguard Intermediate-Term Bond Index Fund ETF stocks and 10-year Treasury bonds. Keep in mind that one of the ETF’s components is a 10-year Treasury bond. The following chart shows the negative relationship between two financial instruments. When the 10-year Treasury yield decreases, the price of the ETF per share increases. This situation occurs because of the negative relationship between bond prices and yields.

The bottom line is to understand the fundamental factors that affect 5-10 year Treasury bonds. To do this, it is necessary to analyze the federal funds rate.

second part

fed

The Federal Reserve System is an institution that aims to maintain financial and monetary stability in the United States. To achieve this goal, the Federal Reserve uses monetary instruments to promote maximum employment and price stability in the United States. Therefore, when inflation is high, the Fed intervenes to reduce inflation to its long-term target level.

Inflation rates are currently one of the Fed’s key priorities. The 2020 coronavirus outbreak has caused annual inflation rates to rise sharply, reaching levels not seen in more than two decades. The following chart shows that even before the 2008 financial crisis, inflation rates had not reached 2022 levels.

In 2020, the United States suffered a sharp economic downturn due to lockdowns. To respond, the Federal Reserve lowered the federal funds rate to below 1% and increased its monetary base. From September 2019 to December 2021, the Monetary Base (MO) increased by more than 100%.

Without high inflation and lockdowns, the Fed’s priorities have shifted. From March 2022 to the present, the main issue has shifted to fighting inflation. For this reason, the Federal Reserve has decided to curb the level of economic activity and raise the federal funds rate. Also in 2021, the Federal Reserve will begin reducing its monetary base to the extent of reducing the stimulus injected into the U.S. economy. That trend has continued to this day.

Fed policy for 2023

I want to focus my analysis on January-December 2023 because it gives me more insight into Fed policy. First, it is important to examine the relationship between the federal funds rate and inflation. From May 2023 until now, the federal funds rate has been higher than inflation, indicating positive real interest rates in the U.S. economy. As of December 2023, the gap between the federal funds rate and inflation was 2%. The yield on secondary market U.S. government bonds with a maturity of one year is 4.57%. This means that when you purchase government bonds, you gain purchasing power over your investment. The Federal Reserve aims to reduce the amount of money circulating in the economy by raising the federal funds rate. Less money means fewer transactions in the U.S. economy, which reduces inflationary pressures.

For January 2023 and 2024, the Federal Reserve announced an inflation target of 2%. The current annual inflation rate is 3.1%, so a further fall of 1.3% is needed to reach the 2% target. The previous chart shows how inflation has fallen, but since June 2023 it has fluctuated within the 3% range. The Federal Reserve has been cautious about raising interest rates because it does not want to hurt the economy. But there is a reason why inflation has not fallen. Again, call volumes have been increasing since June 2023, with an annualized change of 7.2% in December 2023.

From my perspective, there could be another increase in the federal funds rate to between 0.25% and 1%. However, since inflation would need to fall by 1.3% to achieve the 2% inflation target, values ​​above 0.5% seem unlikely.

Federal Funds Rate and 10-Year Treasury Bonds

As mentioned in the previous section, the 10-year Treasury note is a proxy for evaluating the performance of Vanguard Intermediate-Term Bond Index Fund ETF shares. So in this section we will look at the long-run relationship between the federal funds rate and the 10-year Treasury bond.

Establishing long-term relationships between variables is essential in finance because it helps find patterns that continue to emerge over many years.

The previous chart clearly shows the relationship between the federal funds rate and the 10-year Treasury note. If the federal funds rate falls sharply, the yield on the 10-year Treasury note falls. An interesting consideration is the length of time the federal funds rate (red line) is above the 10-year Treasury note. You will find that when the federal funds rate falls, so does the 10-year Treasury note.

danger

Vanguard Intermediate Term Bond Index Fund ETF Shares are priced at $75.86 per share. From my perspective, if the Fed changes its strategy and starts cutting the federal funds rate, I could see the ETF grow up to $88 in 3-5 years, which represents a 16% gain. A bond coupon of about 2-3.5% should be added each year.

In a worst-case scenario, prices could fall by around 70.5%. I chose these numbers based on historical data. When this event occurs, you will lose 7.07%.

conclusion

High interest rates in the United States are a direct result of the Federal Reserve’s efforts to reduce inflation, which led it to raise the federal funds rate to 5.25%-5.50%. However, the analysis presented in this article suggests that the Fed will probably finalize its high interest rate policy in the coming months. This change will cause U.S. Treasury yields to fall and the price per share of the Vanguard Intermediate Term Bond Index Fund ETF to rise.

Lastly, the Vanguard Intermediate-Term Bond Index Fund ETF Shares has the distinction of having its constituents being investment grade bonds. Because it is a safe investment, the price per share will not rise or fall excessively.