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Summary The Vanguard Short-Term Corporate Bond Index mutual fund is everything I would hope for in a short-term corporate debt exposure. The mutual fund has low volatility and low correlation with other important investments. The Federal Reserve may push up yields and put high quality bond funds on sale in December. The Vanguard Short-Term Corporate Bond Index Admiral Shares (MUTF: VSCSX ) is simply a great fund. I wish I could start more articles out with comments that are this positive. This fund is simply great. The yields are severely limited since this is short term debt with respectable credit quality, but the ETF on the whole is just exceptional when it comes to being part of an effective portfolio. Duration The following chart breaks down the duration of the funds. Holdings are almost all less than 5 years and usually more than 1 year. Again, this is a solid choice. If an investor wants to load up on even shorter term bonds, there are funds designed specifically for that. It is difficult to find a useful yield level on those ultra-short bonds so this is a reasonable portfolio composition. Credit The following chart shows the credit quality breakdown. When it comes to a corporate bond fund there are two ways that I like to see the weightings. Either I would want a junk bond fund or I would want one with a credit breakdown similar to this. Personally, favor combining a fund like this with quite a few other bond funds to create a more complex group of bond holdings. Sector The following chart breaks down the sector allocation: This sector allocation may seem absurd if an investor looks at numbers without reading the names. The names of the sectors indicate that rather than breaking down the market into all the corporate sectors, Vanguard is containing several other bond sectors that are not relevant to corporate debt. It wouldn’t make sense for this fund to have an allocation to foreign debt issues or MBS. Portfolio Usage When the mutual fund is placed within the context of a portfolio that is heavy on U.S. equities it looks like an intelligent way to reduce the overall risk of the portfolio. When it comes to generating alpha, I’ve often told investors that the secret to reaching alpha is to focus on reducing risk. (click to enlarge) Most other investors are already focused on trying to maximize their returns and many will take on more risk than they can handle. Focusing on risk reduction reduces the incentives for an investor to sell off after a big loss and makes it easier to generate alpha relative to the S&P 500 because it is easier to reduce risk through superior diversification. In this case we can see that the return on the fund was fairly weak over the last several years, but the annualized volatility has also been fairly low. When consider that the total risk contribution to the portfolio is negative due to the fund having a negative correlation with the S&P 500, the impact on risk adjusted returns is much more favorable than it would have appeared at first. These bonds do take on some credit risk as corporate debt, but the fund is not holding junk bonds so the credit risk is not material enough to outweigh the impact of a small amount of duration risk. As a result, investors end up with a negative correlation between this fund and most domestic equity funds. One Risk Factor The biggest risk factor for this portfolio right now is the potential for share prices to drop if the Federal Reserve is able to raise rates in December. I’m treating an increase in rates as a buying opportunity for any rate sensitive asset. That could mean bond funds, equity REITs, mREITs, or utilities. Regardless, I’d like to have a little cash available this December to see if the Federal Reserve is able to push some of the investments I want into the bargain bin. Another Use Investors that want to keep a fairly short amount of duration exposure in their portfolio while maintaining higher yield may consider this bond fund as part of an automatic allocation strategy within retirement portfolios. The yields aren’t going to be incredible, but for an investor that is feeling particularly risk averse this is a fairly nice fund. Since volatility is fairly low, it isn’t likely to move up or down very far, but it does offer some gains over time while making the portfolio less risky. Conclusion This mutual fund offers high quality corporate debt that will offer superior yields to treasuries but it still has a negative correlation with equity securities. The return is severely limited by short duration and high credit quality combining to create very low yields on the bonds, but it still makes sense for investors looking for some less volatile investments. If the Federal Reserve moves to raise rates it could put this fund on sale for a bit in December which would create a nice buying opportunity. Scalper1 News
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