Seeking Alpha
Registered investment advisor, CFA, portfolio strategy, macro
Profile| Send Message| ()  

Suppose you’re investing for income. You likely want to be conservative with your asset allocation, given all of the turbulence that has rocked investment markets in recent years. Perhaps you’re also looking ahead and see the rising threat of inflation and the potential for higher interest rates in the future. With all of this in mind, you may decide you want to shorten the duration in your bond portfolio in an effort to dial down risk. But when it comes to your U.S. corporate bond allocation, such a transition may not be as straightforward as it seems. Instead, it might come with some unexpectedly new exposures.

If you’re investing for income, it’s likely that you own the LQD. This is the iShares iBoxx $ Investment Grade Corporate Bond Fund ETF, which is by far the largest credit bond ETF both in terms of market cap ($13.3 billion) and average daily volume (934,000 shares). The LQD is made up mostly of well-recognized U.S. corporate bonds and has a 4.7% yield -- but it also has an effective duration of 7.2 years.

This latter number is a measure of the ETF’s sensitivity to changes in interest rates. To simplify, if interest rates fall by 1%, the value of the bonds in the ETF will rise in aggregate by 7.2%. But on the flip side, if interest rates rise by 1%, the value of the bonds in the ETF will fall in aggregate by 7.2%. So if you’re worried about the threat of rising interest rates going forward, or even if you simply want to take some risk off the table following a +60% gain in corporate bonds over the last two-plus years, you may be looking to shorten your duration.

The most obvious first choice for a shorter duration U.S. corporate bond alternative is the CSJ. This is the iShares Barclays 1-3 Year Credit Bond Fund ETF. The CSJ is a logical choice for several reasons. First, it stands as the second-largest credit bond ETF, again in terms of both market cap ($7.9 billion) and average daily volume (498,000 shares). It is also an ETF that in is the same iShares family as the LQD. Lastly, you’re still getting a reasonable yield at 2.2% while still slashing your effective duration all the way down to 1.9 years. You can even go so far as to look at the CSJ’s benchmark, which is the Barclays Capital U.S. 1-3 Year Credit Bond Index, which suggests that it keeps its holdings to those names found inside the United States. Thus, on the surface, the move from LQD to CSJ looks like a natural transition in providing a comparable basket of U.S. corporate bonds with a lower duration. But this is not necessarily the case.

A look under the surface reveals that the CSJ provides some unique exposures that one might not expect. While the LQD mostly holds a standard roster of U.S. corporate bonds, the CSJ does not. Instead, this short-term offering travels all around the world, with over 26% of the portfolio in sovereign, supranational and non-U.S. agency bonds. All of the debt is U.S. dollar-denominated, but many of the borrowers reside elsewhere. The following is a list of the 10 largest non-U.S. issuers and their percentage of the overall CSJ portfolio:

  1. 6.19% European Investment Bank
  2. 4.30% KFW Bankengruppe
  3. 1.60% International American Development Bank
  4. 1.46% Oesterreichische Kontrollbank AG
  5. 1.40% Ontario (Province of)
  6. 1.18% Italy (Republic of)
  7. 1.06% World Bank – International Bank for Reconstruction & Development
  8. 1.04% Landwirtschaftliche Rentenbank
  9. 1.00% Export Development Canada
  10. 0.62% Japan Bank for International Cooperation

Identifying these exposures in CSJ is not a commentary on the quality of these holdings. They may be great investments; then again, they may not be. Nor is listing these exposures intended to be a knock against the CSJ. After all, the CSJ is known as the 1-3 Year Credit Bond Fund. Its name neither specifies corporate bonds nor the United States.

But it is certainly not a list made up of household names like AT&T (T), General Electric (GE) and Wal-Mart (WMT). Instead, it is a list of holdings that is likely unfamiliar to many and perhaps even difficult to pronounce in some cases. At a minimum, further analysis of the underlying holdings in this ETF would be prudent to fully understand these exposures before either taking on a position in CSJ or transitioning from LQD to CSJ to lower U.S. corporate bond portfolio duration.

More specifically, given the ongoing sovereign instability in the euro zone, some of the names on the list might raise an eyebrow for the risk-averse, income-oriented investor. For example, Italy is one of the “PIIGS," so such an investor would want to make sure that he's at least aware that over 1% of his investment allocation to a short-term credit ETF benchmarked to the Barclays Capital U.S. 1-3 Year Credit Bond Index is allocated to the Italian government.

So suppose you would still like to reduce your U.S. corporate bond portfolio duration but would rather avoid the additional exposures provided by the CSJ. Two alternatives are available that provide more dedicated allocation to the short-term U.S. corporate bond market.

First is the Vanguard Short-Term Corporate Bond ETF (VCSH), which has a yield of 2.0% and an average duration of 2.8 years. It ranks as the fourth-largest credit bond ETF, with a market cap of $1.7 billion and an average daily volume of 205,000 shares. It is benchmarked to the Barclays U.S. 1-5 Year Corporate Bond Index, which helps explain the longer duration relative to the CSJ.

Another is the SPDR Barclays Capital Short Term Corporate Bond Fund ETF (SCPB), which has a yield of 1.4% but a shorter average duration than the Vanguard offering at 1.9 years. In terms of size, it ranks seventh in the credit bond ETF category, with a market cap of $333 million and an average daily volume of 90,000 shares. It is benchmarked to the Barclays U.S. 1-3 Year Corporate Bond Index.

Bottom line, the CSJ may provide some unexpected exposures for those investors seeking to establish or transition to a short-term U.S. corporate bond position in their portfolios. These exposures include holdings in sovereign, supranational and non-U.S. agency bonds from regions all around the world. If an investor has concerns about specific non-U.S. holdings in the CSJ, both the VCSH and the SCPB offer viable alternatives to obtain more pure short-term U.S. corporate bond allocations.

Disclosure: I am long LQD.

Source: CSJ: Short-Term Fund With Potentially Unexpected Holdings