The Vanguard Total Bond Market Index Fund ETF (NASDAQ: BND) is taking a beating this year. It is doing better than stocks, but its 14.5% selloff has many investors worried. If bonds fall along with stocks, is there something there really safe?
Truth be told, BND is probably safer than most funds you could buy. It is less volatile than stocks and offers a yield of 3.73% (higher than the average stock). Today, BND suffers from not beating the yield on 2-year Treasury bills. However, the fund could become a great buy in 2023, as I will explain in the following paragraphs.
To prove that BND might be a good buy next year, I’ll have to take a look at the fund’s characteristics. If BND were to drop 10% with the same risk profile it has now, it would already be a great buy. However, it does not have such a yield, so from today it exposes investors to the risk of not compensating for the rate of inflation.
The key statistics on BND are:
An annualized return of 3.73%.
An MER of 0.03%.
A bid-ask spread of 0.01%.
4.975 million in daily volume.
Immediately, most of these features jump out at you as very desirable. The fees are among the lowest in the ETF industry, the spread is virtually zero and the level of diversification is enormous. This fund has pretty much everything ETF investors are looking for on paper.
However, there is a small problem:
The BND yields 3.73% while the 2-year Treasury bond yields 4.1%. Treasury bills are considered risk-free, but BND is not: it includes many corporate bonds, some of which are rated BBB or lower. Thus, the high-risk investment has the lowest return. This looks set to be offset over time by the continued sale of assets held by BND, which will in turn cause the price of BND to decline.
Indeed, the price of BND is trending lower and should continue to do so as long as the Fed continues to raise interest rates. When the Fed raises rates by selling Treasuries, it lowers their price by increasing their supply. The Fed doesn’t determine yield on its own (enough demand can overwhelm Fed selling), but it is large enough to move the yield on Treasuries in the direction it wants. Treasuries owned by BND will drop when the Fed sells them. As the chart below shows, the value of Treasuries on the Fed’s balance sheet has declined by $96 billion since June 8, so the sell-off continues.
The BND’s own holdings aren’t the same as what the Fed sells — that includes some corporate debt and some miscellaneous. obligations. However, rising Treasury yields tend to depress the price of riskier bonds, as it is impossible to justify investing in a riskier asset for a lower return. Thus, the Fed’s interest rate decisions in the coming months will affect ALL BND holdings, not just Treasuries.
Speaking of BND holdings, it’s time to take a closer look at them. As the name suggests, BND invests primarily in bonds. That in itself doesn’t say much. There are all kinds of different bonds, just like there are all kinds of different stocks, and the differences between them can be substantial.
According to BND’s factsheet, the fund’s major asset classes and their weightings are:
US government bonds (67%).
Corporate debt rated AAA (3.8%).
Debt rated AA (3%).
A rated debt (11.8%).
Debt rated BBB (14.3%).
Debt rated below BBB (0.1%).
It’s a pretty diverse set of different levels of risk. In addition to those listed above, we may see some mortgage-backed securities as we scroll through the fund’s annual report. So there is a bit of everything. Some specific obligations it holds include:
US Treasury bonds of various maturities.
AbbVie (ABBV) with a coupon of 4.2%.
American Express (AXP) with a coupon of 3%.
Abbott Laboratories (ABT) with a coupon of 4.9%.
Some of these bonds have quite high yields, but again, the 2-year treasuries have them too. Investors can buy treasury bonds directly from their bank or from online vendors, so they are reasonable alternatives to funds like BND.
What are the advantages of BND compared to Treasury bonds?
The most obvious is diversification. With 10,178 bonds, BND is one of the most diversified funds in the world. Thus, it offers less risk than an individual bond theoretically does. However, it is not clear that the logic of diversification makes sense when the opportunity cost is cash. US Treasuries are considered the safest investments in the world, so much so that people refer to their returns as the “risk-free rate of return”. Diversification is supposed to protect you against a specific risk – the risk of an asset as opposed to market risk – but what about assets that have almost no risk? You cannot “diversify” a risk that does not exist.
Admittedly, when people call Treasuries “risk-free,” they’re just using shorthand for “least risky asset.” Treasuries are literally not without risk: the federal government has already come close to defaulting (due to political deadlocks), and it could theoretically default in the future. However, Treasuries are low-risk enough that it’s hard to imagine other assets thriving when they fail. If the United States ever defaults, it would imply that the government is going through a fiscal crisis, which would be bad for corporate bonds, stocks, and everything else.
In this sense, BND’s allocation to corporate debt could be seen as increasing risk rather than decreasing it. Sure, BND has a lot of bonds, but compared to the least risky stock on earth, it’s more exposed to risk. Therefore, it is difficult to justify buying BND at a lower yield than the Treasury. This seems to be a “more risk for less return” proposition.
Why I have my eye on 2023
After explaining all the reasons why BND is not very attractive right now, I can explain why I think it will become more attractive in 2023.
The first observation here is that the Fed behaved exactly as announced this year. He increased the rates at each meeting. The rate hikes were of a similar magnitude to what they hinted at before making them. There was no pivot.
It seems the Fed’s plan here is to do what it always said it would do, which is to keep rising until it hits a terminal rate somewhere between 4 .5% and 5%. Many people like to bet that the Fed will eventually pivot, on the theory that the pain of high interest rates will knock them off course, but there’s little reason to think that way. If anyone thinks the Fed is going to pivot because they’re going to be scared of the consequences of the rate hike, they’re essentially armchair psychoanalysis. No academically sound investment philosophy endorses this type of thinking. The default assumption should be to expect Fed officials to do what they say they will do.
Given this, we can reasonably expect the highest rates to be reached in 2023. Officially, the Fed’s plan is to rise until inflation begins to decline, but it signaled that the target range is 3% to 3.25%. The maximum target range is expected in 2023 at 4.6%. For rates to rise that high, bonds will have to fall much further. Therefore, buying BND in 2022 may be premature.
Note that the Fed forecast has a hard deadline: 2023. Fed officials did not specify which month or quarter in 2023 it would be, but whether we are at a 4% policy rate in the first quarter of 2023 , it will be safe. assume that BND is approaching its maximum return. Remember that all bonds are correlated with other bonds and the yield on Treasury bills tends to move in the same direction as the key rate. So if the Fed behaves as it says, we should see yields peak next year. I can’t tell you what time it will be next year, but a 4% funding rate in 2023 seems like a good buy trigger. I know that, personally, I would consider an investment in BND if these conditions were met.
As for BND’s yield lagging the 2-year treasury: it appears to be partly a function of the inverted yield curve. The yield on 10-2 year Treasury bonds tends to reverse before recessions and then gradually normalize as the recession nears the bottom. BND holds bonds at all sorts of different durations: its 3.73% yield actually beats the 10-year Treasury yield, which is 3.68%. So, if the yield curve normalizes going forward, BND will enjoy a better yield than short-term Treasuries: another factor indicating that it will be more buyable next year than this year.
The bottom line about BND is that it is a reasonably safe fund that, at present, simply does not compete with Treasuries. The yield curve is inverted and some of BND’s long-term debt offers lower yields than 2-year Treasury bills. From today, you better ask your bank for Treasury bills and CDs rather than buy this fund. However, history shows that inverted yield curves don’t last forever. Sooner or later, long-term bonds will become attractive, and on that date, BNDs will be purchasable. As for me personally, I am aiming for 2023.