VCLT ETF: A Systematic Risk Assessment (NASDAQ:VCLT)

The U.S. Corporate bond market makes for an exciting discussion in the current interest rate environment, given the volatility embedded in implied interest rates and risk premiums. Moreover, real economic factors are shifting, meaning opportunities such as duration management may come into play soon.

In light of the radically changing corporate bond market environment, we decided to dial in on the Vanguard Long-Term Corporate Bond Index Fund ETF Shares (NASDA:NASDAQ:VCLT). VCLT has enjoyed a scintillating time of late, skyrocketing by more than 8% (at the time of writing this article) month-on-month. Although its recovery is somewhat warranted, VCLT possesses a few overlooked risks to take notice of. As such, today’s article balances the pros and cons to formulate a judgment call.

We covered the ETF earlier this year and decided that the bond market environment’s radical shift ever since warrants an update. Let’s traverse in the analysis.

An Overview of VCLT ETF

As its name says, the Vanguard Long-Term Corporate Bond Index Fund ETF Shares invests in long-term bonds. However, let’s delve into its mandate and portfolio composition to garner a better understanding of the vehicle’s key functions.

VCLT is benchmarked to the Bloomberg U.S. 10+ Year Corporate Bond Index with some freedom to implement tracking errors. Furthermore, the fund’s effective maturity of 22.6 years suggests it is very long-dated, especially considering that effective maturity accounts for early expirations via exercised options.

I plotted the fund’s maturity structure below. Note that its duration composition is subject to change as time passes. Nevertheless, its current exposure shows that the fund generally avoids maturities below ten years and implements a laddered allocation thereafter.

Most of VCLT’s asset mix is A and BBB-rated, meaning credit risk comes into play. What do I mean by credit risk? I’m referring to incremental changes in the probability of default and losses given default. Moreover, liquidity risk plays a key role, as many of VCLT ETF’s holdings are positioned at market values above $10 million, which is a substantial amount to offload at once.

A final consideration about the fund is its hefty exposure to cyclical sectors. For example, nearly 70% of VCLT ETF’s portfolio comprises industrial issuers, while more than 15% includes financial services companies. The fund’s benchmark may reconstitute or rebalance as time passes; however, the fact remains that its current portfolio is highly exposed to cyclical risks, contemporaneously amplifying its sensitivity to credit risk.

What’s In Store?

Top-Down Factors

Let’s discuss the yield curve to start this section.

Firstly, the yield curve’s month-over-month decline is no surprise, as continuous disinflation paired with softening consumer sentiment was always going to lead to a lower curve. We believe the curve will level down even further in 2024, providing latitude for treasury securities to surge.

However, there are a few additional matters to consider when it comes to corporate bonds. Firstly, a lower yield curve might imply that a recession is about to occur, which is supported by the fact that the slope of the curve continues to decline. Real economic factors also play into the equation. As mentioned before, consumer sentiment is waning, and unemployment numbers are rising.

We believe we may be in for a surprise if real economic softening and implied interest rate reductions enhance. Our outlook is based on two factors. Firstly, a contractionary economic environment could enhance credit spreads, adding downward pressure on corporate bond prices. Secondly, once a contraction is reached, we could see a steepening in the yield curve, which will likely spike the term premium and lower long-dated corporate bond prices.

Despite all of the potential risks, we believe that risk premiums on long-dated corporate bonds deserve a “neutral” rating until further data emerges. The level of the curve is in an outlying position and could revert to its mean in due course. If such an event occurs, we could see the level itself fend off other premiums, such as credit risk and term, especially considering that VCLT ETF holds high-quality corporate bonds that are not overly vulnerable to rating downgrades.

Bottom-Up Variables

Let’s look at VCLT ETF from a bottom-up vantage point.

Firstly, take notice of the interest coverage ratios in the United States. The industrial sector, which is VCTL’s largest sectorial bet, has experienced a recovery in this past quarter after a near year-on-year decline. In our view,…