I have loved the Investment Grade Corporate Bond market for the last several years. But after holding a position in the iShares iBoxx $ Investment Grade Corporate Bond Fund ETF (NYSEARCA:LQD) since the days immediately following the outbreak of the financial crisis in late 2008, the time has finally come to exit this position. It’s not a question of asset class fundamentals, as they remain generally strong. Instead, the reason to sell is driven by some less-than-desirable exposures to the financial sector in the LQD that I’d like to avoid for now.
The Investment Grade Corporate Bond market continues to offer a great deal to like even today. Many higher quality companies are flush with cash, the asset class provides generally consistent performance over time with a low correlation to stocks, and it tends to perform well during periods of economic weakness. All of these factors set up well, particularly in the current post QE2 environment with the economy showing signs of deceleration.
Given all of these positives, what would drive the decision to sell the LQD? Put simply, the exposure to the threat of another financial crisis emanating from Europe. Roughly 38% of the LQD is allocated to the financial sector, which would be most at risk if events were to begin dissolving in the Euro Zone.
Of this 38%, nearly 9% comes directly from European banks including Barclays, Royal Bank of Scotland, Deutsche Bank (NYSE:DB), BNP Paribas (OTCQX:BNPQF) and Lloyds (NYSE:LYG). If the situation in Europe deteriorates to the point where Greece is forced to effectively default or Italy succumbs to financial market pressure, it is the European financial institutions that would be most directly impacted.
Moving down the line, another 28% is invested in U.S. financial institutions (the remaining 1% comes from Canada and Japan) including JP Morgan Chase (NYSE:JPM), Citigroup (NYSE:C), Bank of America (NYSE:BAC), Goldman Sachs (NYSE:GS) and Morgan Stanley (NYSE:MS). While the direct exposure to the European sovereign debt crisis is relatively less with these institutions, it is still relevant. For example, Citigroup has a $31 billion exposure to Italy. Moreover, all of these institutions are intertwined with their European banking counterparts to at least some degree, thus the contagion risks associated with any type of sovereign debt breakdown are very much real.
An added issue is the persistent lack of visibility surrounding exactly where the risks lie within the financial sector in the event of a default. While some degree of clarity exists around where the first and even second derivative impacts would be felt in the event of a Greek default or a full-blown regional sovereign meltdown, it is the additional fallout effects on the financial system unforeseen by policy makers until after the crisis has erupted that can result in the most damage.
The Investment Grade Corporate Bond market has held up well to this point, and the asset class still looks strong technically, but the risks are mounting as we move through the summer. Sovereign yields and CDS across the Europe have been rising for weeks, and the threat of a default event is rising by the day. And such an event would likely be accompanied by declining asset prices and potentially considerable liquidity shocks that can have a particular impact on ETFs. For example, the LQD lost -4% intraday during the flash crash on May 6, 2010, before recovering by the close. And the LQD lost -25% over the course of four weeks during the depths of the financial crisis in late 2008, before rebounding.
Given these risks, the decision to step aside from a broadly defined Investment Grade Corporate Bond exposure in the LQD is based on prudence. Looking ahead over the next several weeks, I see limited further upside but the possibility for considerable downside. As a result, I will likely be looking to get back into the LQD at some point over the next few months, either under a stable scenario where prices are not meaningfully different from where they are now, or perhaps under a stress scenario like we saw in late 2008, where the opportunity becomes available to step back in and buy at discounted prices as the dust begins to settle. In the meantime, I will be reallocating to more specific investment opportunities within the asset class that offer an attractive risk/reward profile.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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.