Rising levels of public debt could lead to the tightening of the yield premium of investment-grade corporate bonds over U.S. Treasuries.
Corporations will arguably manage debt more responsibly than successive U.S. administrations have proven to be.
The Vanguard Total Corporate Bond ETF has outperformed the iShares Core U.S. Aggregate Bond ETF offering in recent years, and risk is rising with the latter.
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The iShares Core U.S. Aggregate Bond ETF(NYSEMKT: AGG) is a suitable option for investors seeking bond exposure in their portfolios. That said, the Vanguard Total Corporate Bond ETF(NASDAQ: VTC) is a better option for long-term investors on a risk/reward basis. Here’s why.
The stated aim of this ETF is to “track the investment results of an index composed of the total U.S. investment-grade bond market.” As such, it holds high-quality debt deemed to have a relatively low default risk. Based on S&P Global’s ratings, the ETF currently holds just 12.07% of its funds in BBB-rated bonds (the lowest investment-grade debt rating), with 75.5% in bonds rated AA- or above.
As you might expect, and indeed hope for, the majority of this bond ETF’s assets are invested in U.S. Treasuries and government-backed mortgages.
Data source: iShares presentations. *Substantive holdings in corporate bonds in industrial, financial, and utility company bonds.
In short, it’s a relatively safe bond ETF with a very low expense ratio of 0.03% and a 30-day SEC yield of 4.45%. It’s exactly the sort of bond fund that risk-averse investors might want to include in their portfolio to help balance the rising levels of risk faced by their equity holdings.
The Vanguard Total Corporate Bond ETF owns investment-grade corporate debt, but a similar mix of corporate debt to that held by the iShares ETF.
Data source: Vanguard presentations.
Investors buy bonds and often gauge their yields based on a perception of risk. Traditionally, U.S. Treasuries have been considered among the lowest-risk bonds available. After all, the world economy would likely be in very serious trouble if the U.S. defaulted on its debt. That’s why other bonds, including the corporate bonds held in the Vanguard Total Corporate Bond ETF, tend to trade at higher yields.
Those higher yields reflect their greater default risk. This is why the Vanguard Total Corporate Bond ETF has a 5.24% 30-day SEC yield while iShares ETF has a 30-day SEC yield of only 4.45%.
The chart below, which displays their 12-month trailing yields, also illustrates this point.
AGG Dividend Yield data by YCharts.
But here’s the thing. Given the seemingly ever-rising levels of public debt in the U.S. — an issue that has been criticized by Elon Musk among others — and the costs of servicing that debt, investors are entitled to ask who they trust more to demonstrate financial discipline in response to potentially rising interest rates: corporations or the U.S. government?
Interest rates on public debt could rise simply due to the ongoing need for more of it to be issued to support rising debt servicing levels and more spending. Meanwhile, increasing public debt may encourage investors to shy away from holding dollar-denominated assets or reduce the weighting of their assets held in dollars. That could be a negative for the value of the U.S. dollar.
Image source: Getty Images.
To be clear, rising U.S. interest rates (Treasury yields) are not good news for corporate America, as they will push corporate bond yields up (and send corporate bond prices down). However, there are a couple of things to bear in mind:
Many U.S. corporations are global in scope and earn money internationally, too, so all things being equal, a weakening of the dollar will improve their ability to cover interest payments on dollar-denominated debt.
The argument here is about a relative shift in risk; if government debt becomes relatively riskier, all things being equal, corporate debt should become more attractive.
To put it succinctly, the spread between the yields on investment-grade corporate debt and public debt will get smaller, and so will the spread between these two ETFs.
Fundamental Chart data by YCharts.
Indeed, this spread tightening is one reason why the Vanguard ETF has outperformed the iShares ETF in recent years.
AGG Total Return Level data by YCharts.
If you share the view that U.S. public debt is likely to keep rising, then it makes sense to expect the market to price that risk in. If you also share the view that this will lead to investment-grade corporate bonds outperforming, then the Vanguard ETF is a better option.
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Lee Samaha has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.
AGG Is a Great Choice for Most, but I Like This Vanguard ETF Better was originally published by The Motley Fool
