As a retiree, I am always searching for sources of high income at a reasonable risk. This week I decided to analyze investment grade corporate bonds. A bond is considered investment grade if it is rated BBB or higher by Standard and Poor's (Baaa3 or higher by Moody's). These ratings mean that the rating agencies believe the companies issuing the bonds have an adequate amount of financial strength to pay the bond interest and not default. Because there is still a slight risk of default, investment grade corporate bonds yield more than treasuries with a comparable maturity.
You could buy individual bonds but I do not have the time nor expertise to select a diversified mixture of bonds. Thus, I favor investing in professionally-managed bond funds, mainly Closed End Funds (CEFs) and Exchange Traded Funds (ETFs). Among these two vehicles, I usually choose CEFs because many sell at discounts to their Net Asset Value (NYSE:NAV) and offer higher yields than ETFs.
However, yield is not everything. As a retiree, risk is as important to me as return. So this article analyzes the risks and rewards associated with investment grade bond CEFs, where risk is measured by volatility and reward is synonymous with the total return.
There are about 16 CEFs that have investment grade corporate bond portfolios. To reduce the number of funds to be analyzed, I selected candidates based on the following criteria:
- At least 5 years of history.
- Market Cap greater than $150 million.
- Average trading volume greater than 50,000 shares per day.
The following 5 funds satisfied all of these conditions. It should be noted that although these funds are classified as investment grade bond funds, the portfolios may have a significant percentage of non-investment grade securities.
- BlackRock Credit Allocation Income (NYSE:BTZ). This CEF sells at a discount of 10.3%, which is a smaller discount than the 5 year average discount of 11.6%. The portfolio contains 627 securities with 72% invested in corporate bonds and 17% in preferred stock. About 68% of the holdings are currently investment grade, but the management team has the flexibility to shift allocations according to economic conditions. The fund utilizes 31% leverage and has an expense ratio of 1.2%. The average weighted duration (adjusted for leverage) is 5.2 years. The fund has not had a losing year (based on price) since 2008 but in 2015 the price appreciated while the NAV fell by 2.5%. The distribution is 7.9% made up on income with no return of capital (NYSE:ROC).
- Western Asset Global Corporation Defined Opportunity (NYSE:GDO). This CEF sells at a discount of 10.4%, which is a larger discount that the 5 year average discount of 7.6%. The portfolio consists of 319 securities, with 78% in corporate bonds (51% investment grade) and 15% in emerging market debt. The fund utilizes 23% leverage and has an expense ratio of 1.5%. The average weighted duration (adjusted for leverage) is 7.8 years. The fund was launched in 2009 and in 2010, the price decreased 2.5% while the NAV increased over 11%. Similarly, in 2013, the price decreased 6% while the NAV increased 3.5%. In 2015, both the NAV and price decreased about 3%. . The distribution is 8.6%, funded primarily by income but with a small amount of ROC.
- Putnam Master Intermediate Income Trust (NYSE:PIM). The CEF sells for a discount of 9.2%, which is a larger discount than the 5 year average discount of 7.8%. The fund has a portfolio of 1203 securities with 73% in mortgage backed securities and 25% in high yield bonds. This is a relatively high quality portfolio with 52% in AAA rated bonds (with an additional 12% in investment grade below AAA). About 80% of the securities are from companies domiciled in the United States. The fund does not use leverage and the expense ratio is 0.90%. The fund is unusual in that the effective duration is actually a negative 2.4 years, which theoretically means the fund holdings may increase in value if interest rate rise. Since 2008, the price of this fund has not had a negative year except for 2011 when the price (and NAV) dropped by 5%. The yield is 7.2%, funded by income with no ROC.
- PIMCO Corporate & Income Strategy (NYSE:PCN). This CEF sells for a discount of 2.1%, which is unusual since the fund has sold for an 8% average premium over the past 5 years. In fact, the fund sold at a premium as high as 25% and did not drop to a discount until May, 2015. The portfolio has 270 securities, with 40% in corporate bonds, 32% in asset backed securities, and 15% in short term debt. About 44% of the holdings are investment grade. The fund utilizes 23% leverage and has an expense ratio of 0.8%. The average weighted duration (adjusted for leverage) is 3.2 years. Since 2008, the fund has not had a loss in price except in 2015 when the price dropped 2.43% (even though the NAV was up 3.6%). The loss in price was due to the erosion of the premium. The distribution is 10%, funded from income with no ROC.
- PIMCO Corporate & Income Opportunities (NYSE:PTY). This fund sells for a premium of 2.7%, which is a smaller premium than the 5 year average premium of 15.5%. Over the last 5 years, the premium has reached as high as 29% and has ventured into discount territory only in 2015. The portfolio has 300 securities with 40% in asset backed bonds and 40% in corporate bonds. About 47% of the holdings are investment grade. The fund utilizes 20% leverage and has an expense ratio of 0.6%. The average weighted duration (adjusted for leverage) is 3.7 years. Like its sister fund, this fund has not had a negative price year since 2008 with the exception of last year when it lost 6% (even though the NAV increased 2.5%) due to deterioration of the premium. The distribution is a high 11.8%, funded by income with no ROC.
For comparison with bonds, I also included the following ETFs in the analysis:
- iShares iBoxx $ Investment Grade Corporate Bond (NYSEARCA:LQD). This is a pure investment grade corporate bond ETF, which tracks over 1,500 bonds primarily from the industrial (63%) and financial (34%) sectors. All the bonds are investment grade with 41% BBB, 46% A, 11% AA, and 2% AAA. The fund has an effective duration of 8.1 years. The fund has not had a losing year since 2008 except in 2013 when the fund lost 2.5 %. The fund broke even in 2015. The expense ratio is 0.15% and the yield is 3.5%. This ETF will be used to compare the performance of the CEFs with a passively managed investment grade corporate bond fund.
- iShares 7-10 Year Treasury Bond (NYSEARCA:IEF). This ETF tracks the performance of Treasury bonds with an average duration of about 7 years. The expense ratio is 0.15% and the yield is 1.9%. This fund will be used to compare the performance of the CEFs with a passively managed intermediate Treasury fund.
- SPDR S&P 500 (NYSEARCA:SPY). This EFT tracks the S&P 500 and is a good proxy for overall market performance. Since SPY is equity based, it is not a good metric to compare with the performance of bond funds. It was included in the analysis only for comparison of volatility and to help assess CEF diversification.
To analyze the risks and return of the Investment grade CEFs, I used data over the past five years (1/29/2011 to 1/29/2016). The results are shown in Figure 1, which plots the rate of return in excess of the risk-free rate of return (called Excess Mu on the charts) against the historical volatility. To make comparisons easier, I assumed zero as the risk-free rate.
Figure 1. Risk versus reward over past 5 years
As is evident from the figure, investment grade bond funds had a wide range of returns and volatilities. Are the returns associated with these funds commensurate with the risk? To answer this question, I calculated the Sharpe Ratio.
The Sharpe Ratio is a metric, developed by Nobel laureate William Sharpe that measures risk-adjusted performance. It is calculated as the ratio of the excess return over the volatility. This reward-to-risk ratio (assuming that risk is measured by volatility) is a good way to compare peers to assess if higher returns are due to superior investment performance or from taking additional risk. In Figure 1, I plotted a red line that represents the Sharpe Ratio associated with LQD. If an asset is above the line, it has a higher Sharpe Ratio than LQD. Conversely, if an asset is below the line, the reward-to-risk is worse than LQD.
Some interesting observations are apparent from Figure 1.
- BTZ had the best risk-adjusted performance among the CEFs.
- BTZ exhibited significantly less volatility than the general stock market as measured by SPY.
- BTZ had the smallest volatility among the CEFs. This is likely because BTZ had the highest percentage of investment grade bonds among the CEFs analyzed.
- BTZ had a higher absolute return than either LQD or IEF but also had higher volatility. On a risk-adjusted basis, BTZ had essentially the same risk-adjusted performance as LQD and IEF. Thus, the higher volatility associated with BTZ was rewarded by commensurate returns.
- LQD had the lowest volatility followed closely by IEF.
- The PIMCO funds (PCN and PTY) were the most volatile, with a volatility that exceeded the general stock market. The increased volatility was not adequately rewarded with commensurate returns.
- The two funds that had the largest distributions (PCN and PTY) lagged in risk-adjusted performance, only beating PIM. Thus, high distributions do not necessarily translate into superior total return.
Bonds (especially investment grade) have been touted as providing portfolio diversification. To be "diversified," you would choose assets such that when some assets are down, others are up. In mathematical terms, you want to select assets that are uncorrelated (or at least not highly correlated) with each other. To assess the diversification potential of investment grade bond funds, I calculated the pair-wise correlations associated with these funds. The results are shown in Figure 2.
Figure 2. Correlation matrix over past 5 years
As shown in the figure, none of the assets were highly correlated with the overall stock market, making these funds good selections for diversification. In addition, none of the CEFs were highly correlated with one another, except for PTY and PCN, which have a correlation of 72% (this was not surprising since both are managed by PIMCO). Overall, investment grades bonds funds did provide excellent diversification.
Next I next wanted to see how these funds performed during more recent times, so I reduced the look-back period to 3 years and reran the analysis. The results are shown in Figure 3.
Figure 3. Risk versus reward over past 3 years
What a difference a couple of years made! During the past 3 years, investment grade bonds did not provide great performance, probably due to the specter of interest rate hikes. GDO sunk below the zero line and PIM, PCN, and PTY all hovered close to break even. However, BTZ was still the outstanding performer among the CEFs, matching LQD and IEF on a risk-adjusted basis.
In summary, investment grade bond CEFs offered mixed performance, depending on the time period. All the funds had substantially lower risk than the overall stock market. BTZ was the clear winner among CEFs and offered good returns with a risk just slightly above intermediate Treasury bonds. The 7.9% distribution definitely satisfies my desire for income. It is true that BTZ is not a pure investment grade fund and has some preferred holdings along with some high yield bonds. However, the management team has been able to blend these in a way that increases return without unduly increasing volatility. BTZ has also been awarded a "bronze" rating by Morningstar and it if you are looking for an investment grade fund, I would recommend BTZ.
Disclosure: I am/we are long BTZ.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.