Corporate Bonds: Is There Upside?

Corporate bonds have had a very consistent performance record.  iShares iBoxx $ Investment Grade Corporate Bond (LQD) returned 12.1%, 9.1%, 8.9%, and 11.7% per year from 2009 to 2012. Is this level of performance realistic going forward? We think the answer is no. That doesn't mean you should avoid corporate bonds, but you should have realistic expectations about future returns.

Corporate Bond Basics
High-quality corporate bonds offer relatively safe income and typically yield more than United States Treasury bonds because of their credit risk. Long-term investors could own LQD as part of a diversified-bond allocation, and tactical investors could own this exchange-traded fund when they feel the corporate-bond market is underpriced versus Treasuries. This fund holds investment-grade paper with an average rating of BBB. Still, that does not make the fund immune to losses, even if the actual creditworthiness of its underlying companies remains unchanged. Corporate spreads can widen, inflicting losses on funds like this one, because of factors such as liquidity and changing opportunities in other areas of the fixed-income market.

Investors should also be aware that a corporate-bond ETF such as LQD often has substantial overweightings to certain sectors relative to the S&P 500. For example, LQD has a 33% weighting in financials compared with the 15% weighting in the S&P 500. Also, like all bond funds in general, this ETF is subject to inflation and interest-rate risk. The market currently expects inflation of 2.1% over the next five years. If inflation expectations or interest rates rise, the value of the underlying bonds will decline.

Fundamental View
LQD has had very strong inflows over the last two years as investors have flocked to fixed income. With over $25 billion in assets, it's by far the largest corporate-bond ETF. The second-largest fund only has $5 billion. LQD has an average trading volume of 2 million shares per day, giving it substantial liquidity; in many ways it has become the de facto proxy for the corporate-bond market.

Tremendous demand for corporate bonds and actions by the Federal Reserve have lowered yields to historical lows. The BofA Merrill Lynch US Corporate BBB Index had a yield of 9.8% in January 2009. Today the index has a yield of 3.3%, which is near historical lows. Steadily falling rates would explain the above-average returns that investors have received over the past four years.

On a credit-spread basis, corporate debt looks a little more attractive. The BofA Merrill Lynch US Corporate BBB Spread Index, which calculates the difference in yield between an AAA U.S. Treasury bond and a BBB rated corporate bond, shows a spread of 1.94% as of Jan. 9. The average spread since 1997 is 2.13%. While spreads are below average, they're not extremely overvalued. 

LQD has an average credit quality of BBB and SEC yield of 2.78%. The Fed has pledged to keep interest rates low for the foreseeable future, so investors should expect returns between 2% and 4% over the next few years. It is unlikely that rates will drop much more, so investors won't be able to rely on capital gains going forward.

The biggest risk to an investor is the potential for rising interest rates. With an average duration of 7.8 years, LQD is heavily exposed to this risk. If rates rise just 1%, LQD would have about an 8% loss.

Portfolio Construction
LQD tracks the corporate-bond market as defined by the Markit iBoxx USD Liquid Investment Grade Index. The index tracks a basket of representative investment-grade corporate-bond issues that have a maturity of between three and 25 years. The fund holds more than 1,000 bonds and has an average duration between seven and eight years. The average credit rating of the fund is BBB. As of January 2013, the sector breakdown for the fund was 34% financials, 12% consumer staples, 11% oil and gas, 8% telecom, 8% consumer goods, and 8% health care.

Fees
LQD charges a 0.15% management fee, which is on par with other corporate-bond ETF offerings.

Alternatives
There are three direct competitors to LQD in the intermediate-term corporate-bond space. They are  iShares Barclays Credit Bond (CFT),  Vanguard Intermediate-Term Corporate Bond Index ETF (VCIT), and PIMCO Investment Grade Corporate Bond Index ETF (CORP), which carry expense ratios of 0.20%, 0.12%, and 0.20%, respectively. All alternatives have a slightly shorter duration than LQD. High trading volumes and a large asset base give LQD stronger liquidity, which makes it the preferred fund in this category.

Investors looking for shorter-duration credit bond exposure might want to look at  iShares Barclays 1-3 Year Credit Bond (CSJ). This fund has a duration of only about 2.0 years, and its holdings include investment-grade sovereign debt as well as corporate issues.

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