Profiting From The Spreads With Investment Grade And High Yield Bond ETFs

|
 |  Includes: HYG, ITE, LQD, VCIT, VGIT
by: Lawrence Weinman

A key tool in positioning bond strategies is to watch the spreads, in this case credit spreads. That would be the differential between what are considered riskier bonds (investment grade and high yield bonds) to Treasuries considered free of credit risk (although no longer unanimously).

As can be seen from the graph below the interest rate spreads (differentials) can vary quite a bit. But there is a strong reversion to the mean. Looking at the graph below showing the spread between investment grade corporate bonds and Treasuries, I would put that mean value at around 1,5% to 1.7%.

So what does one do when one watches the spreads in corporate bonds vs. treasuries? The reader is probably ahead of me here. Buy corporate bonds when the yield differential is above the mean. My instrument of choice is VCIT, the Vanguard Intermediate Investment Grade Bond ETF. Also a choice would be LQD. the equivalent ETF from iSshares. Since LQD has been around longer than the ETF, the fund is used for evaluating performance.

Looking at VCIT vs. the Treasury Equivalent ETF, VGIT, one can see the spread has widened of late to around 1.8%. Looking at that number as well as the index I would give VCIT a somewhat below target allocation especially since the yield is about the same as the GNMA fund.

What happens when interest rates go up? Given the relatively short duration of the portfolio the decline in principal value would be relatively modest with most or all of it offset by increases in interest rates. And of course it is almost always the case with bonds that their interest rate will adjust with inflation as investors demand a positive real return.

But in watching the spreads the really interesting opportunities come when the spreads move way above the long term mean. That occurs in the extreme in flight to quality market conditions when spreads move to extreme values. Take a look at the spread chart above at the beginning of the article for the period beginning in 2008.

For the patient investor the pattern of reversion to the mean is so strong that spreads "blowing out" to the levels of late 2008 is a big fat pitch down the middle of the plate. Think about it: In the midst of a major crisis that involves government bailing out financial companies, the yield on the highest rated corporate bonds moved to 7% above Treasuries.

This kind of opportunity allows for the prospect of high equity like returns for an investment grade corporate bond investor. In such situations the yield on corporate bonds would move well above GNMA funds and the appropriate strategy would be to reduce the target allocation in VFIIX and increase the allocation in VCIT. This requires patience and discipline, even if the investor began to do this at a spread of 5% and saw it move to 7% initially. Putting his position at a loss, he must have faith in the long term reversion to the mean even adding to the investment.

Sure enough this is what the returns for GNMA Intermediate Term Treasuries and Intermediate Term Corporate bonds looked like (iShares ETFs are used because Vanguard bond ETFs were not available for the entire period):

Treasuries (NYSEARCA:ITE)

Corporate Bonds (NYSEARCA:LQD)

GNMA

2008

11.3%

2.4%

7.2%

2009

-1.6%

8.5%

5.3%

2010

4.7%

9.3%

6.8%

Click to enlarge

The chart below shows three-year returns for 2008 to 2010 coporates vs. for treasuries (return top, volatility bottom).

It should be quite clear from the example above that watching the spreads makes sense, whether to get a bit extra yield in the current environment or to benefit from an abnormal movement in spreads. My clients have taken advantage of both of these. A bond allocation shouldn't be a trading portfolio but neither should it be static.

Without going into detail a couple charts will show that a similar strategy could be implemented using one of the high yield bond ETFs, HYG and JNK.

Here is the current yield differential vs government - it's currently around 5.5%.

Here is the history of the high yield/treasury spread, again the same pattern of a massive increase in spreads by a sharp tightening.

So it shouldn't be surprising that returns in 2009 were massive for high yield investors. Below 2009 returns for LQD corporate bonds, SPY, HYG high yield, ITE treasury bonds (return top, volatility bottom).

And here is growth of $10,000 in 2009.

This should show the usefulness of "minding the spreads" in one's bond allocation. The bond allocation shouldn't be used as a trading position but neither should it be set with no response to major changes in the markets as reflected in the spreads between instruments. The strong tendency for reversion to the mean in spreads gives ample opportunity to profit from anomalies.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: Mr. Weinman's clients have positions in HYG JNK VCIT and LQD.