A Solid Choice for Exposure to the Investment-Grade Corporate-Bond Market

IShares iBoxx $ Investment Grade Corporate Bond ETF LQD is a solid choice for exposure to the investment-grade corporate-bond market. The fund's fee is low, and it harnesses the market's collective wisdom about the relative value of each security. But its portfolio is not fully representative of its opportunity set, as its index excludes bonds with less than three years remaining until maturity, and there are cheaper alternatives. It earns a Morningstar Analyst Rating of Bronze.

LQD tracks the Markit iBoxx USD Liquid Investment Grade Index, which includes investment-grade corporate bonds with more than three years remaining until maturity. The three-year cutoff excludes a sizable portion of the corporate-bond market and results in a portfolio focused on intermediate- and long-term bonds. The index is weighted by market value, tilting the portfolio toward the largest, most liquid issues.

Reflecting the composition of the market, the strategy maintains a fair amount of credit risk. It heavily tilts toward the lower end of the investment-grade spectrum. Approximately 90% of its portfolio is invested in bonds rated A and BBB. Roughly 50% of the fund's assets are invested in BBB rated debt, which matches the corporate-bond Morningstar Category average.

The portfolio courts more interest-rate risk than most of its category peers. Its average effective duration is approximately 9.0 years, while the average effective duration of the corporate-bond category is approximately 6.5 years. The fund will likely underperform its category peers during periods of rising interest rates as a result and fare relatively better when interest rates fall.

Fundamental View Reflective of its opportunity set, the strategy's exposure largely mirrors its corporate-bond category peers. However, given its focus on longer-date issues, the fund courts more interest-rate risk. Its average effective duration is approximately 2.5 years longer than the category average. This helped its performance during the trailing 10 years through February 2020, a period in when interest rates were generally declining. However, the additional interest-rate sensitivity will likely hurt the fund's performance during periods of rising interest rates. It performed worse than the category average by over 150 basis points during the first three quarters of 2018, when the yield on the 10-year Treasury increased from by 68 basis points (from 2.46% to 3.14%).

Approximately half of the fund's assets have a credit rating of BBB, the lowest possible rating for investment-grade debt. While the downgrade risk of BBB rated issuances is generally low, the strategy would suffer should some of these issuances be downgraded to junk because it is unable to own below-investment-grade issuances. The fund would be required to liquidate these issues, and the forced selling would likely result in the fund trading at a large discount. The strategy's BBB rated debt exposure is on par with the category average, so many other funds would also be seeking to offload these issues, thereby raising their supply in the market.

Additionally, given its focus on BBB rated issuances, the strategy will suffer during periods of widening credit spreads. For example, the ICE Bank of America BBB OAS Spread widened by 3.55% during the onset of the coronavirus crisis between Feb. 20 and March 23, 2020, and the fund fell 14.83%. During periods of weakening business conditions, credit spreads widen as the market requires more compensation for the additional risk, and safer securities tend to outperform lower-rated securities.

But this broad market-value-weighted portfolio relies on the market's collective wisdom to assess the relative value of its holdings, effectively betting that the market is offering a fair deal. There are some criticisms of market-value-weighting bond index funds, most notably the idea that assigning larger weightings to more heavily indebted issuers seems illogical. But larger issuers tend to be larger companies with the necessary resources to effectively service their debt.

In the fixed-income market, risk and reward are closely related. The market knows what the future cash flows of investment-grade bonds will be with greater certainty than stocks. Accordingly, there is less room to find an informational edge, and it would be difficult to construct a bond portfolio with market-beating returns without taking additional risk.

The strategy is one of the cheapest funds in its category, which should give it a durable edge. It builds on its expense ratio advantage by mitigating transaction costs and market-value-weighting its holdings, favoring the most-liquid bonds in the market, which also tend to be the cheapest to trade.

Portfolio Construction This portfolio provides exposure to a broad set of investment-grade corporate bonds, free-riding on the collective wisdom of investors through market-value weighting. This is a sound approach because it is cost-effective, it promotes low turnover, and the market does a decent job pricing these bonds. However, the fund is not truly representative of its opportunity set as it excludes bonds with less than three years remaining until maturity.

This strategy employs representative sampling to track the performance of the Markit iBoxx USD Liquid Investment Grade Index, which includes investment-grade corporate bonds with more than three years until maturity. Qualifying bonds must have at least $750 million in outstanding face value, tilting the strategy to the most liquid issues, which are easier to track and help to mitigate transaction costs. Bonds are weighted by their market value, subject to a 3% issuer cap. The index is rebalanced monthly.

Fees The strategy has an expense ratio of 0.15%, ranking in the category's second quartile. While cheap, there are a handful of market-value-weighted funds charging slightly less.

Alternatives Silver-rated iShares Broad USD Investment Grade Corporate Bond ETF USIG (0.06% expense ratio) offers more than LQD for less. It tracks the ICE BofAML US Corporate Index, which includes liquidity-screened U.S.-dollar-denominated investment-grade corporate debt with at least one year until maturity. This strategy offers greater exposure to the investment-grade corporate-bond market than LQD, as it does not exclude issues with less than three years until maturity, and it is 9 basis points cheaper.

Silver-rated SPDR Portfolio Intermediate Term Corporate Bond ETF SPIB (0.07% expense ratio) tracks the Bloomberg Barclays Intermediate US Corporate Index, which includes U.S.-dollar-denominated investment-grade corporate bonds with between one and 10 years until maturity. This strategy carries less interest-rate risk than LQD because of its exclusion of issues maturing after 10 years, which should allow it to provide better protection during periods of rising interest rates.