Many investors are evaluating their risk exposures given the persistent threat of a sovereign crisis emanating from Greece and the eurozone. While lowering allocations to stocks is an obvious approach to reduce risk, assessing exposures in other areas may be less straightforward. This includes the Investment Grade Corporate Bond market, where many are invested either through mutual funds or exchange traded funds. In most cases, these products have a sizable exposure to the European financial system that should be considered. Thus, dissecting these products to understand your actual exposures to a financial crisis event from the eurozone is important in setting your overall asset allocation.
Overall, the Investment Grade Corporate Bond market has been an outstanding performer since the days following the financial crisis. As discussed in my recent post Investment Grade Corporate Bonds: Quality, Performance and Income in Any Market, the asset class offers appeal for both a QE and non-QE market environment. However, a primary risk for the asset class would be the outbreak of another financial crisis. And this risk is relevant today considering the events currently percolating in Europe.
To highlight how Investment Grade Corporate Bond products have exposure to the situation in Europe, I will focus on the iShares iBoxx $ Investment Grade Corporate Bond Fund ETF (LQD), which is by far the largest investment grade corporate bond ETF. While allocations are not exactly the same, the list of underlying holdings for the LQD is very similar to competing products such as the Vanguard Intermediate-Term Corporate Bond Index ETF (VCIT), the PIMCO Investment Grade Corporate Bond ETF (CORP) as well as the various mutual funds that also cover the space.
The financial sector is the segment of the corporate bond market that would likely face the most immediate pressure from an outbreak of a European sovereign debt crisis. Similar to the Lehman collapse in 2008, one of the key risks is the uncertainty over exactly what financial institutions are exposed to the final losses that may result from a sovereign default and to what degree. Concerns are particularly pronounced for European banks, not only because these institutions generally have a greater exposure to the sovereign debt in the region, but also since many are also less capitalized then their U.S. counterparts.
Dissecting the holdings in the iShares iBoxx $ Investment Grade Corporate Bond Fund ETF (LQD) reveals a notable direct exposure to European financials. Exposure by country is listed below (all percentages are as of June 21, 2011).
- United Kingdom: 4.18% of total ETF investment
- Switzerland: 2.71%
- Germany: 0.74%
- France: 0.71%
- Spain: 0.09%
In total, 8.43% of an investment in the LQD is allocated to European financial institutions. This is a size that can meaningfully impact overall performance and should not be ignored. Although neither Greece, Portugal nor Ireland shows up on the list, many of the financial institutions from these countries listed above are major holders of the debt considered at risk in the event of a default. For example, banks in the United Kingdom, France and Germany have all been widely reported as being the most exposed to Greek sovereign debt.
The following is a list of the LQD’s largest specific financial institution exposures in Europe:
- Credit Suisse (CS), Switzerland: 1.67%
- HSBC (HBC), UK: 1.48%
- Barclays (BCS), UK: 1.21%
- Royal Bank of Scotland (RBS), UK: 1.03%
- UBS (UBS), Switzerland: 1.03%
- Deutsche Bank (DB), Germany: 0.74%
- BNP Paribas (OTCQX:BNPQY), France: 0.71%
- Lloyds (LYG), UK: 0.46%
Of course, one of the key risks associated with a financial contagion is not knowing where the final losses actually reside. While it is believed that the exposure of U.S. financial institutions is relatively less and thus more manageable, at a minimum it would be reasonable to expect that this segment of the market may also come under pressure in the event of the outbreak of a eurozone debt crisis. As a result, it is worthwhile to evaluate the remaining non-European financial exposures.
The allocation to U.S. financial institutions in the LQD is 28.09%. Canadian and Japanese financial institutions make up another 0.67% and 0.40%, respectively. Thus, more than one third of all exposures in the LQD are dedicated to the global financial sector. The following is a list of the largest U.S. banking institutions found in the LQD.
- J.P. Morgan Chase (JPM): 3.00%
- Citigroup (C): 2.95%
- Goldman Sachs (GS): 2.95%
- Morgan Stanley (MS): 2.91%
- Bank of America (BAC): 2.82%
- Wells Fargo (WFC): 2.78%
- GE Capital (GE): 2.61%
- AIG (AIG): 1.20%
- American Express (AXP): 1.17%
- MetLife (MET): 0.74%
As mentioned, many investment grade corporate bond products have similar exposures to the financial sector in general and European financials in particular. As events unfold, it is worthwhile to evaluate your specific investments in the sector to determine whether these allocations are appropriate for your circumstances.
With this idea in mind, one final point is worth highlighting. As discussed in my previous post CSJ: Short-Term Fund With Potentially Unexpected Holdings, if you own an Investment Grade Corporate Bond ETF with the word “Credit” in its name, you also have exposures that go beyond the corporate bond market discussed here including sovereign, supranational and non-U.S. agency bonds. This is an additional element of risk that must be considered as well.
While the Investment Grade Corporate Bond market has performed well since the financial crisis and presents an attractive investment opportunity in a post QE2 environment, the current sovereign debt risks in Europe must be watched carefully. Given the meaningful exposure in the Investment Grade Corporate Bond market to the financial sector in general and the European financial sector in particular, a default event and potential crisis outbreak would likely result in downside pressure on performance for the asset class.
Disclosure: I am long LQD.
Disclaimer: This post is for information purposes only. There are risks involved with investing including loss of principal. Gerring Wealth Management (GWM) makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by GWM. There is no guarantee that the goals of the strategies discussed by GWM will be met.