Corporate Bonds: Time to Back up the Truck?

by: Chance Carson November 24, 2008 | about: AGG / BND / LAG / LQD

Chance Carson

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Many of our readers at AboutETFs.com have shown increased interest not only in US Government backed bonds, but in Investment Grade Corporate bonds as well. The prevailing question seems to be “should I shift entirely out of corporate bonds, even investment-grade corporate bonds, and move my bond allocations into US Government paper?”

For ultimate safety of principal, of course, one should stick with Treasury Bills. The rub is in the yield – or lack thereof. With current yields on T-bills at 0.25% or lower, we do not see the risk-reward value. Why not have your cake and eat it too? How about considering a hybrid solution of blending short US Government bonds with short and intermediate term investment-grade corporate bonds?

In the ETF universe today, several obvious selections surface immediately. Three index ETFs currently track the Lehman Aggregate Bond Index: (AGG) – iShares Lehman Aggregate Bond Index (BND) – Vanguard Total Bond Market, and (LAG) – SPDR Lehman Aggregate Bond ETF. Each of these three ETFs attempts to replicate the Lehman US Aggregate Bond Index which is diversified into three asset classes: Treasury and Agency Bonds (approximately 37%), Mortgage-backed Securities (38%) and Investment-Grade Corporate Bonds (25%). Maturities in this index are relatively short with 39% of the portfolio maturing in one year or less and another 34% maturing in less than five years. The average maturity is currently 6.8 years.

State Street’s LAG - SPDR Lehman Aggregate Bond ETF with its modest $10 million market cap and low trading volume of 32,200 shares daily should probably be avoided. While Vanguard’s BND - Vanguard Total Bond Market is an excellent choice, our vote goes to Barclay’s AGG - iShares Lehman Aggregate Bond Index. AGG is the granddaddy on the hilltop with its $9.3 billion market cap and daily 732,500 shares trading volume.

Performance and yield of the Lehman Aggregate Bond Index and its three index tracking ETFs has been excellent this year. From the Lehman Brothers collapse on September 15, 2008, to the market trough on October 10, 2008, AGG dropped 14.9%, BND lost 14.2% and LAG was down 16.6%. The ensuing recovery has been dramatic. AGG and BND have recovered 12% and LAG is up 17%. Year to date performances through November 19, 2008 are a 3.8% loss for AGG, 3.6% loss for BND and a mere 1.2% loss for LAG. Current distribution yields are 4.9% for AGG, 4.8% for BND, and 4.5% for LAG.

There is one primary candidate for a 100% investment grade corporate bond ETF – LQD – iShares iBoxx $ Investment-Grade Corporate Bond Fund. By holding 100% in corporates, as expected, the current distribution rate trumps our three hybrid government/corporate selections. LQD is distributing a robust 5.75%, but this higher yield has come at a cost. During the September 15 to October 10 market sell-off, LQD dropped 25.4% nearly matching the S&P 500 precipitous 33% decline. LQD has recovered 19.1% since the October 10 turnaround. Year to date, LQD has lost approximately 13.5%, nearly four times the year to date losses of AGG, BND and LAG. Since September 15, money has been aggressively flowing out of corporates into governments. Can we say “flight to safety?”

LQD seeks investment results corresponding to the price and yield performance of the “iBoxx $ Liquid Investment Grade Index.” This index measures the performance of 100 highly liquid, investment-grade, US dollar-denominated corporate bonds that offer maximum liquidity and represent the broader US corporate bond market. The average duration of bonds held by LQD is 6.25 years, daily trading volume exceeds 800,000 shares, and market cap is $3.7 billion.

So, what’s our conclusion and advice? Is it time to back up the truck and load up on pure corporates? NO WAY! The extra 75 basis points in yield may be intriguing, but when it comes to the bond allocation part of your portfolio stick to quality, blending only a modest percent into corporates. The winning choice in hybrid investment-grade bond ETFs is AGG. Check it out – you’ll be pleased with what you discover.