Week 26 Day 4: VCIT: Corporate Bonds for Steady Income

Corporate bonds are IOUs from companies like Apple, JP Morgan, and Johnson & Johnson. VCIT holds thousands of these bonds from companies rated BBB or higher (investment grade). You lend money to the company; they pay you interest every month. The risk is very low because these are financially strong companies.

VCIT by the numbers: Expense ratio: 0.04%. Yield to maturity: approximately 5.0-5.5% (as of 2024, varies with rates). Duration: approximately 6.2 years (intermediate sensitivity to rate changes). Holdings: approximately 2,100 investment-grade corporate bonds. Credit quality: approximately 50% A-rated, 45% BBB-rated, 5% AA/AAA-rated. Why VCIT over BND (Total Bond Market)? BND holds approximately 45% government bonds (Treasuries) and approximately 55% corporate/securitized bonds. VCIT is 100% corporate bonds, which carry a credit spread premium (approximately 1.0-1.5% higher yield than equivalent Treasuries). Over time, this extra yield compounds significantly with minimal additional risk: investment-grade default rates are approximately 0.1-0.3% per year. VCIT in a portfolio: use VCIT as your fixed income allocation when you want higher income than Treasury-only funds (VGSH, VGIT) but lower risk than high-yield bonds (HYG, JNK). A 20-30% allocation to VCIT in a retirement portfolio provides meaningful income with modest volatility. Risk: in a severe credit crisis (like 2008-2009), corporate bond spreads widen and VCIT can fall 10-15%. However, over 5+ year holding periods, the credit premium has reliably exceeded the credit losses.

Investment-grade corporate bonds occupy an interesting position in the risk/return spectrum. The credit risk premium (the excess return over Treasuries for bearing default risk) has been documented by Elton, Gruber, Agrawal, and Mann (2001) at approximately 0.8-1.5% for BBB-rated bonds over the full credit cycle. However, the actual default loss rate for investment-grade bonds is far lower than the spread implies: the long-term average default rate for BBB-rated bonds is approximately 0.3% annually (Moody's data, 1970-2020), and the recovery rate upon default is approximately 40-50%. This means the expected loss rate is approximately 0.15-0.18% annually, while the spread compensating for this risk is approximately 1.0-1.5%. The difference (approximately 0.8-1.3% annually) is the 'credit risk premium' -- the compensation investors receive for bearing systematic credit risk. This premium has been positive in approximately 90% of rolling 5-year periods, making investment-grade corporate bonds an attractive complement to equities. The intermediate duration of VCIT (approximately 6.2 years) creates moderate interest rate sensitivity: a 100 basis point parallel shift in the yield curve produces approximately a 6.2% price change. In 2022, when rates rose approximately 300 basis points, VCIT fell approximately 15% on a total return basis. However, the higher reinvestment rate means that within approximately 6 years (the duration), the total return will exceed the return that would have been earned at the old, lower yield -- a concept known as the 'crossover point' in fixed income mathematics (Homer and Sylla, 2005).