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A Top-Rated ETF for Exposure to Long Bonds

A version of this article was previously published on Aug. 8, 2019.
As fears of rising interest rates have abated, fixed-income investors have been creeping back out to the farther reaches of the yield curve. Over the 12 months through October 2019, exchange-traded funds in the long-term bond Morningstar Category have amassed $4.1 billion in net new inflows. This equates to 53% organic growth in this figure on a year-over-year basis--the highest reading since the year ended in October 2014. Here, I highlight one of our top-rated ETFs within the category.
Vanguard Long-Term Bond ETF is a compelling choice for exposure to long-term investment-grade bonds. Its well-constructed index and cost advantage underpin its Morningstar Analyst Rating of Silver.
The portfolio delivers market-value-weighted exposure to U.S. corporate and government bonds with maturities of 10 years or longer by tracking the Bloomberg Barclays U.S. Long Government/Credit Float Adjusted Index, which tilts toward high-credit-quality investments. However, the fund takes significant interest-rate risk, making it vulnerable to rate movements.
The fund's long duration, which is currently 15 years, introduces considerable interest-rate risk. Just over 77% of the portfolio was invested in securities with effective maturities of 20 years or more at the end of June 2019. The fund's duration is about two years longer than the long-term bond category average. It offers a slightly higher yield than its typical peer as compensation for this risk.
While the fund's interest-rate risk is high, its credit risk is low. It only invests in investment-grade bonds while its category peers, on average, allocate about 7% of their assets to below-investment-grade securities. Market-cap-weighting tilts the portfolio toward Treasury bonds, which currently make up roughly 43% of the portfolio, compared with the category average of 16.5%. These high-credit-quality holdings have helped the fund outperform during market downturns, including the global financial crisis and Greek debt crisis.
The fund boasts a long record of tightly tracking its index since its inception in April 2007. From inception through June 2019, the fund gained 7.06% annually, matching the performance of its spliced benchmark. The fund is cheaper than the vast majority of its category peers, which gives it a durable advantage.
Fundamental View
Investing in a market-value-weighted bond index, like stock indexing, has advantages. For a low fee, the indexed portfolio replicates the composition of the fixed-income market and reflects the collective views of market participants about the value of each security. But there are some drawbacks.
Market-value-weighting skews the portfolio toward the largest debt issuers, leading to a sizable weighting in low-yielding government-related securities. This large weighting is not representative of how many active managers invest. This is because the fixed-income market includes large investors who have objectives other than maximizing risk-adjusted performance. For example, banks often invest their reserves in Treasuries, and life insurance companies use long-term Treasury bonds to manage their long-duration liabilities.
This fund has the longest duration in the category, exposing investors to considerable interest-rate risk, though it does compensate with a higher yield than funds with lower duration and similar credit risk. At the end of June 2019, bonds with effective maturities of 20 years or longer made up more than three fourths of the portfolio, lengthening the portfolio duration. The average maturity of Treasury securities has become longer in recent years. Since 2009, the U.S. Treasury Department started issuing longer-term Treasury bonds to address long-term Medicare and Social Security expenses, while taking advantage of low interest rates.
The portfolio's interest-rate risk is partially offset by its low default risk. Compared with the typical category peer whose investments include high-yield securities, this fund has greater exposure to high-credit-quality bonds. In fact, the fund's exposure to securities with an AAA rating, the highest credit rating attainable, was more than 9 times the category average of just shy of 5% as of June 2019. Treasury bonds account for most of this exposure, making up around 43% of the fund, nearly 27 percentage points more than the category average as of June 2019. These bonds have virtually no default risk since the government can raise taxes to repay the debt.
The fund's bias toward highly rated bonds has provided downside protection in the past. For example, during the global financial crisis (2007), the fund gained 8.7% when the category average return was negative 0.6%. The fund also outperformed its category average by 500 basis points during Greek debt crisis (2011).
Portfolio Construction
The fund's high-credit-quality bias and well-constructed index should help it generate strong category-relative risk-adjusted performance over a full market cycle. Its market-value-weighting approach mitigates transaction costs by tilting toward the most-liquid securities. It earns a Positive Process Pillar rating. The fund employs a sampling methodology designed to track the performance of the Bloomberg Barclays U.S. Long Government/Credit Float Adjusted Index. This index includes issues of U.S. government, investment-grade corporate, and investment-grade international U.S.-dollar-denominated bonds that have more than 10 years until maturity. Qualifying bonds must have at least $300 million in par value outstanding. The fund samples the index, but attempts to replicate the index's key risk factors, including credit and interest-rate risk, sector composition, and other characteristics. The fund maintains a dollar-weighted average maturity consistent with that of the index, which generally ranges between 15 and 30 years. It rebalances on the last business day of each month.
The fund has an expense ratio of 0.07%, which is among the lowest in the long-term bond category, underpinning the Positive Price Pillar rating. This fund is cheaper than the vast majority of its category peers. From its inception in April 2007 through June 2019, the fund matched the performance of its spliced benchmark.
IShares Core 10+ Year USD Bond ETF invests in both investment-grade and high-yield corporate bonds with maturities of 10 years or longer. The fund's wider reach results in a slightly a higher yield than BLV. Its duration-risk profile is in line with the long-term bond category average. This fund charges 0.06%, making it an attractive alternative for yield-seeking investors.
Pimco Long-Term Credit Bond is an actively managed fund that relies on bottom-up fundamental credit research to identify attractive investment-grade bonds. It includes both corporate and noncorporate sectors, such as sovereign, supranational, foreign agency, and foreign local government, with at least 10 years until maturity. It charges a higher 0.79% expense ratio, but its 7.07% five-year return through July 2019 handily beat both BLV and the category average.
>Ben Johnson, CFA does not own shares in any of the securities mentioned above.

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