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An ETF for Diversified, Low-Cost Exposure to Investment-Grade Corporate Bonds

The fund is far and away the largest and most-liquid corporate-bond ETF.

Eric Jacobson, 09/02/2016

iShares iBoxx $ Investment Grade Corporate Bond LQD offers diversified exposure to investment-grade corporate bonds. It may be a suitable satellite holding for investors who want fixed-income exposure with moderate credit risk and a higher yield than government bonds of similar, relatively long duration. Tactical investors could use this fund when they feel corporate bonds are inexpensive relative to Treasuries.

As of Aug. 22, 2016, the portfolio’s weighted average yield to maturity was 2.93%, nearly double that of the 10-year U.S. Treasury, which is arguably pretty good compensation for the increased credit risk that corporate bonds introduce. That is a reasonable comparison given that the fund and the 10-year Treasury have similar durations. It is worth noting, however, that at roughly 9.0 years and 8.6 years, respectively, both take on more interest-rate risk than the average corporate-bond mutual fund (7.1 years) or exchange-traded fund (6.1 years). Meanwhile, those groups typically carry even more rate risk than core bond funds in the intermediate-term bond Morningstar Category, which are typically benchmarked off of the industry-standard Barclays U.S. Aggregate Bond Index, whose duration was 5.5 years at Aug. 22. This fund’s duration clocks in at that comparatively long length because the Markit iBoxx USD Liquid Investment Grade Index upon which it is based holds no bonds with maturities shorter than three years, unlike more-conventional indexes that typically hold bonds with maturities of a year or longer. That may sound trifling, but bonds with maturities from one to three years in the industry-standard Barclays U.S. Corporate Investment Grade Index (which also holds bonds of smaller issuance), for example, comprise more than 20% of that benchmark’s market value and act as a counterweight to the more than 20% in ultra-long bonds that would otherwise further push out the index’s duration.

That has important ramifications given that all of the duration comparisons mentioned above track quite well with the historical volatility of those examples. At 7.1, the 10-year standard deviation of returns for this fund through the end of July 2016 came in just short of the 10-year Treasury’s (7.4). By contrast, the average corporate-bond mutual fund and the Barclays U.S. Aggregate posted standard deviations of 5.9 and 3.2, respectively. (There are no other corporate-bond-focused ETFs with 10-year records).

Those features raise the question of whether it is likely that one will be sufficiently compensated with returns to offset the fund’s risks. In general, investment-grade corporate bonds haven’t historically presented enough credit risk to make that feature worthy of panic, but the margin of their longer-term returns relative to Treasuries has historically been on the thin side: Over the trailing 10 years through July 31, 2016, for example, the fund posted a 6.4% trailing 10-year return, versus 6.2% for the 10-year Treasury. That makes buying corporate bonds when their yields are historically wide relative to Treasuries an important consideration.

The question of whether it is worth taking on this fund’s level of interest-rate risk relative to more-conventional options is a bit trickier, though. Through the lens of a 10-year stretch, it would seem like a tough case to make. Combined with this fund’s notable additional volatility, its 6.4% 10-year return wouldn’t seem large enough in comparison with the average corporate-bond mutual fund’s 6% annualized gain for that period. And in fact, this ETF’s Sharpe ratio, which looks to describe how well an investment has balanced out volatility with high returns, was a bit lower than that of the average corporate-bond mutual fund for the trailing 10 years.

During historically notable shorter periods, however, things have looked more nuanced. When bonds with any whiff of credit risk sold off during the 2008 financial crisis, for example, even most investment-grade corporate-bond funds and widely used indexes were hurt: The average corporate-bond mutual fund swooned 7.9% that year, while the 10-year Treasury--a beneficiary of investors’ mad dash to safety--exploded to a 20% gain. Although it couldn’t compete with that, this fund’s comparatively high rate sensitivity helped it to avoid most of the carnage and eke out a 0.3% loss that year. And while it wasn’t able to keep up with the average corporate-bond mutual fund during the 2009 rebound, it turned in a 12.1% gain, ending the period with a return for both years combined that came out pretty close to even.

It is crucial to note that even 10-year returns that envelope both credit and interest-rate cycles don’t constitute proof of how market segments will act in the future. But the experience of this fund does suggest that while its long-term risk/reward trade-off potential doesn’t appear notable, its extra sensitivity to movements in Treasury bond yields has the potential to keep it out of deeper short-term pain during times of market panic and still provide reasonable long-term return potential. 

Fundamental View
During the past several years, credit spreads and yields of U.S. corporate debt compressed to near all-time lows. And while they bottomed in mid-2014 and widened considerably thereafter, the trend reversed sharply in mid-February 2016. It is not a perfect proxy given this fund’s typically longer duration, but the option-adjusted credit spread between the Barclays U.S. Corporate Investment Grade Index and comparable U.S. Treasuries was 137 basis points as of Aug. 19, 2016. That is still higher than precrisis levels, but while it is possible that central bank polices, for example, could drive them back down, that figure is pretty close to the index average since spreads stabilized back into a more normal range in early 2010.

Corporate bonds--even the high-quality variety--carry more credit and liquidity risk than U.S. Treasuries. But U.S. companies are currently in good shape as they have fortified their balance sheets in recent years and currently have ample cash. The last time an investment-grade-rated company defaulted was 2011, and the average default rate since 1981 for investment-grade debt is 0.11%, according to S&P's 2014 Annual U.S. Corporate Default Study and Rating Transitions publication. The fund has an average credit rating of A, which has a historic default rate average of just 0.10%, according to that report. With a current yield to maturity of 2.93%, the fund's expected yield, net of expense fees and similar losses from default, would be about 2.68%.

Banking firms, which issued bonds typically representing roughly a third of the fund’s assets, have also strengthened their balance sheets in order to comply with the Basel III and Dodd-Frank regulations. The St. Louis Fed Financial Stress Index, which measures the degree of stress in the financial markets, is still close to historic lows, suggesting that financial market conditions are relatively strong.

Industrial firms, which issued bonds representing in the neighborhood of two thirds of the investment-grade corporate market, can be especially sensitive to the business cycle. The private sector of the U.S. economy has improved since 2009, but growth rates have decelerated recently. Moreover, although profit margins are near a 15-year peak, they could face a mild headwind from rising employment costs as wages inch higher and more people join the workforce. A strong U.S. dollar also presents a headwind for many firms' foreign operations. Other concerns, from the perspective of bond investors, include rising M&A activity and increasing corporate leverage. Acquisitions can deplete balance sheets of cash and often result in greater leverage for the acquirer. After retrenching in the wake of the 2008 credit crisis, corporate leverage ratios have started to move higher as growth in new debt issuance has outpaced earnings growth over the past few years.

On the other hand, household debt, as measured by debt service payments as a percentage of disposable personal income, has declined during the past few years. As recently as the fourth quarter of 2007, that ratio stood at 13.2%, whereas as of the first quarter of 2015 it had fallen below 10%. Further, personal spending has increased steadily, while the unemployment rate has fallen to the lowest level since 2007. Improving financial health for consumers is an important trend to monitor, given consumer spending represents about 70% of the domestic economy.

Portfolio Construction
The fund tracks the Markit iBoxx USD Liquid Investment Grade Index, which measures the investment-grade, U.S.-dollar-denominated, fixed-rate, taxable corporate-bond market. It includes publicly issued securities from industrial, financial, and utilities companies that trade on a U.S. exchange. The index weights its holdings by market capitalization and rebalances at the end of each month, but unlike many similar benchmarks stocks with bonds maturing in three or more years. As of August 2016, about 24% of the portfolio is made up of bonds with maturities of three to five years; bonds with five- to 10-year maturities represented 40%, bonds with maturities between 10 and 20 years make up 8%, and bonds with 20 or more years to maturity make up 28%. In terms of credit quality, BBB rated bonds made up the largest chunk of the portfolio with about 45% of total assets, followed by A rated (42%), AA rated (12%), and AAA rated (2%) bonds. The fund currently has an effective duration of 8.6 years and a yield to maturity of 2.93%. Distributions are paid monthly.

Fees
The fund has an expense ratio of 0.15%, which compares favorably with both the ETF and mutual fund corporate-bond Morningstar Category averages. The fund has historically kept in close range of its bogy, typically by an amount very close to its 15-basis-point expense ratio. For the trailing three- and five-year periods through July 2016, however, it has trailed its bogy by 0.27% and 0.21% annualized, respectively. 

Alternatives
The fund is far and away the largest and most-liquid corporate-bond ETF. The second-largest is iShares Intermediate Credit Bond CIU (0.20% expense ratio). Unlike LQD, it invests in both corporate and U.S. government bonds. While that can help performance during turbulent markets, it normally reduces yield as well. That fund has a duration of 4.2 years and yield to maturity of 2.06%.

Vanguard Intermediate-Term Corporate Bond Index VCIT (0.12% expense ratio) could also be a suitable alternative. While it typically sports a shorter duration (6.5 years) than LQD, its most recent SEC yield (2.75%) has historically been fairly close to LQD’s (2.85%). Another cheap option is SPDR Barclays Intermediate Term Corporate Bond ETF ITR (0.12% expense ratio), which had a duration of 4.5 years as of Aug. 23, 2016, and an average yield to maturity of 2.2%.

Investors looking for shorter-duration corporate-bond exposure may consider iShares Barclays 1-3 Year Credit Bond CSJ (0.20% expense ratio). Like CIU, it invests in U.S.-government bonds in addition to corporate bonds. It has a much shorter duration (1.9 years) and lower yield to maturity (1.4%).

 

 

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Eric Jacobson is Morningstar's director of fixed-income research and an editorial director for mutual fund content.

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