SCHI: Attractive Yield But Investors Can Wait Till An Economic Recession

ETF Overview

Schwab 5-10 Year Corporate Bond ETF (NYSEARCA:SCHI) owns a portfolio of investment grade corporate bonds in the United States. This fund has an expense ratio of only 0.03% which is very low relative to many other similar funds. The fund has declined over 23% since reaching the peak towards the end of 2021 and the beginning of 2022. Thanks to the decline in its fund price, SCHI currently offers an attractively yield of about 6.2%. The fund should become even more attractive in an economic recession, which will likely arrive in the first half of 2024. At that time, SCHI’s fund price will likely decline further and the yield will become even more attractive than now. Therefore, investors might want to wait patiently now.

Fund Analysis

SCHI has declined significantly since reaching the peak in end of 2020

Let us take a closer look at how SCHI performed since the end of 2020. As can be seen from the chart below, SCHI has been in a slow decline in 2021 and the pace of decline accelerated in 2022 as the sky-rocketed inflation in the U.S. forced the Federal Reserve to aggressively hike the rate to combat inflation. As a result, SCHI’s fund price started to decline sharply in the same year and reached a trough in October 2022. The fund has declined from the peak by about 23.3%. Although SCHI has rebounded towards the end of 2022, it has resumed its decline in the first half of 2023 and this decline accelerated again towards the second half of 2023.

SCHI has little credit risk

Let us now look at SCHI’s credit risk. As can be seen from the table below, SCHI’s portfolio consists of only investment grade corporate bonds with BBB and A rated bonds consists about 52.0% and 43.2% of its portfolio respectively. In general, investment grade corporate bonds have much lower default rates than high yield bonds. In fact, default rate for 3-years and 15 years investment grade corporate bonds are only 0.41% and 2.66% respectively. In contrast, high yield bonds (non-investment grade bonds) have 3-years and 15 years cumulative default rates of 10.18% and 24.04% respectively. SCHI currently has an attractive 30-Day SEC yield of 6.21%. This yield is much higher than the 0.09% average 1-year default rate of investment grade bonds. Hence, we think SCHI has very little credit risk.

SCHI’s fund price is moderately sensitive to the change in rate

In general, longer duration bonds are much more sensitive to rate changes. In contrast, shorter duration bonds are less sensitive to rate changes. SCHI’s portfolio of treasuries have a weighted average maturity year of about 7.5 years. This duration is intermediate in length. It also means that its fund price is moderately sensitive to the change of rates. Below is a chart that shows the performance of SCHI and its peers since the end of 2020. Although, the current rate hike cycle begun in 2022, the peak of SCHI’s fund price was reached in late 2020 already and has declined slightly in 2021 already. As can be seen from the chart below, SCHI’s fund declined by about 23.3% since the peak reached towards the end of 2020. This decline was worse than its shorter duration peer, Schwab 1-5 Year Corporate Bond ETF (SCHJ), which lost only 9.1% of its fund value. On the other hand, SCHI’s longer duration peer, Vanguard Long-Term Corporate Bond ETF (VCLT) lost nearly 39% of its fund value in the same period.

SCHI’s yield is more attractive than treasury funds

As mentioned earlier in the article, SCHI has a 30-Day SEC yield of about 6.2%. As can be seen from the chart below, the current spreads of A and BBB rated bonds are about 1.13% and 1.60% respectively. As can be seen from the chart below, this spread is in the middle of its historical range. The chart also tells us that the best time to buy investment grade-corporate funds is during significant market selloff, and this usually happens during an economic recession. For example, during the Great Recession, the spread for U.S. corporate A and BBB rated bonds increased to over 6% and 7.5%. respectively. Therefore, income investors should use the opportunity to buy these funds during an economic recession.

In an economic recession, share prices of SCHI could experience a negative spike. This is because investment grade corporate bonds are still perceived as riskier assets than U.S. treasuries. Therefore, it tend to decline sharply when the market is in panic mode. As can be seen from the chart below, during the initial outbreak of the pandemic, SCHI experience significant decline over 12%. Therefore we might see more declines ahead in an economic recession or during extreme market selloffs.

Will there be a recession coming?

Our base case is that there will be an economic recession coming in the first half of 2024. The reason it has not yet happened is because that it generally takes about a year for the change in rate policy to fully propagate through the economy. Since inflation can be quite sticky, we do not think the Federal Reserve will have any room to lower the rate until much later in 2024 or perhaps even until 2025. Hence, a recession is likely inevitable. While SCHI’s yield of 6.2% can be quite attractive, we believe it will become even more attractive during an economic recession. As we have shown in the chart earlier, the spread can be as high as over 6% during an economic recession. Even a mild recession such as the one in 2020, the spread was still over 3% for A-rated corporate bonds and over 4.5% for BBB-rated corporate bonds. Therefore, we think there will be even more attractive buying opportunity for income investors in 2024 than now.

Investor Takeaway

Although SCHI currently offers an attractive 30-Day SEC yield of 6.2%, there will likely be even more attractive opportunities ahead as spreads usually rise sharply in times of market turmoil such as during the Great Recession in 2008/2009 and during the initial outbreak of the pandemic in 2020. Since a recession is likely coming in 2024, we think investors should patiently wait for the event to happen and buy at that time.

Additional Disclosure: This is not financial advice and that all financial investments carry risks. Investors are expected to seek financial advice from professionals before making any investment.