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An Easy Way to Take Advantage of Widened Yield Spreads

February 01, 2012 | About:
Despite the fact that Treasury bond yields remain at historic lows, they continue to be in high demand among fearful investors. As a result, the yield spread between Treasuries and BBB-rated corporate bonds is currently just under 2 percent, while A-rated fare is offering a little more than 1 percent of additional yield. On both counts, these spreads are well above historical averages.

For investors who think another US economic collapse could be imminent, those wide spreads make sense. While we understand such anxiety, we have difficulty supporting that view because of the generally positive economic data that have been released over the past few months. Although this is certainly the weakest recovery of the post-WWII period, the economic data is still trending upward.

Meanwhile, US companies are now extraordinarily lean operations following their aggressive cost cutting in the wake of the Great Recession. All manner of businesses--ranging from financial giants such as Citigroup (C) to industrials such as ITT (ITT)--have cut unprofitable or non-core operations to focus on their top-performing segments. Companies have also strengthened their balance sheets by paring long-term debt levels. Even better, much of their remaining debt was issued at historically low interest rates. These actions have had a positive impact on corporate earnings and have positioned businesses to thrive even during a low-growth environment.

Given this favorable outlook, one way to take advantage of the current widened yield spreads is through Vanguard Intermediate-Term Corporate Bond Index (VCIT).

While BBB-rated bonds are heavily represented at 42.7 percent of the fund’s assets, a 43.9 percent allocation to A-rated bonds and an 11.3 percent allocation to AA-rated debt give the fund an average credit quality of A. As a result, the fund sits squarely in the middle of the credit risk spectrum.

Like most corporate bond funds, Vanguard Intermediate-Term Corporate Bond Index allocates about a third of its assets to the financial sector. That largely reflects the fact that financial sector debt comprises one of the largest slices of the corporate debt market. The financial sector has historically occupied a large share of the corporate bond market, but its share has only gotten bigger as major banks have issued substantially more debt in recent years than firms in other sectors. But that shouldn’t be a major concern, as the fund’s portfolio is bolstered by a 54.5 percent allocation to industrial sector debt and an almost 11 percent allocation to utility sector bonds.

The exchange-traded fund (ETF) currently yields 3.9 percent, which is a better payout than most of the intermediate-term corporate bond ETFs available. That’s due to the fact that the ETF’s portfolio has a slightly longer duration than its peers. At this point, we’re not too worried about an impending jump in interest rates, so the ETF’s longer duration is a worthwhile tradeoff for its higher yield. Nevertheless, we will continue to monitor the market for signs that interest rates could rise.

The ETF has a low annual expense ratio of 0.14 percent. That’s one of the best ETF expense ratios in the space, with the average being 0.22 percent.

About the author:

Benjamin Shepherd
Investing Daily provides stock market advice and investment newsletters to help independent investors achieve a secure and rewarding financial future. The site’s coverage focuses on finding the most profitable emerging trends in the investment universe to bring investors pragmatic and in-depth coverage of the names that are taking advantage of these opportunities.

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