High-Grade Corporate Bond ETFs Eye Perfect Storm

By Murray Coleman

After a year-long rush to safety by bond investors, Treasuries are losing some of their luster.

Since mid-March, yields on 10-Year Treasury notes have jumped nearly 20%. At the same time, corporate bond yields are falling. In the case of junk bonds, that's been especially true. The average yield on the iShares iBoxx InvesTop High Yield Corporate Bond (AMEX: HYG) exchange-traded fund has dropped around 10% in that period.

"Bond investors are clearly giving a vote of confidence to the U.S. economy by moving back into corporates - particularly high-yield," said Joe Clark, managing partner at the Financial Enhancement Group.

That's a sharp contrast from earlier this year as fears of recession and a worldwide credit crisis led investors out of corporate bonds. "Historically, when everyone thinks that a storm is coming, they run to Treasuries for cover," Clark said. "When it looks safe to come outside again, they sell Treasuries and move back into corporates."

Lately, economic data has given signals to investors that the U.S. economy might not be in as bad shape as they thought. And on March 17, JPMorgan (JPM) announced it was bailing out Bear Stearns (BSC), which was flirting with bankruptcy from billions of dollars in losses related to mortgage-backed securities.

But changes in sentiment have been so sudden in the past 12 months that even with their recent sell-off, Treasury yields are still far behind where they were last summer before the credit crisis took hold. The benchmark 10-year note is yielding just around 3.9%, down from 5% last June.

Compare that with a top-rated 10-year corporate bond that's now yielding about 5.6%, up from 5.4% a year ago.

Less Volatility

"Investment-grade corporate yields held firm while Treasuries were tumbling," said Richard Romey, president of ETF Portfolio Solutions in Overland Park, Kan. "Even now, they're still way ahead. They just haven't shown as much volatility as Treasuries."

Since they're not government-backed, corporates generally pay greater income streams than Treasuries. But even within the past few months, spreads between investment-grade corporates and Treasuries remain above historical averages. "We're finding much better deals in corporates right now," said Clark, the Anderson, Ind.-based advisor. "We're preparing to shift more of our clients' assets into those types of ETFs."

He's planning on implementing those changes through iShares iBoxx InvesTop Investment Grade Corporate Bond Index (NYSE: LQD).

So is Romey, who says investment-grade corporates in the past 12 months have proved to be the "steady eddies" in bonds.

"My fear is that Treasury yields fell so much in the past year that if they continue to rise," he added, "their prices will fall much harder than those of investment-grade corporate ETFs."

Several ETFs are available with varying levels of exposure to investment-grade corporate. The Vanguard Total Bond Market ETF (AMEX: BND), for example, tracks the Lehman Brothers U.S. Aggregate Bond Index. It has about 26% of its holdings in corporates.

With its leaning toward government-backed issues, BND's yield of 4.4% is just slightly greater than the 3.6% being paid by the iShares Lehman 7-10 Year Treasury Index (NYSE: IEF). Meanwhile, LQD is yielding close to 5.7%.

"Investment-grade corporates aren't highly correlated to junk or Treasuries," Romey said. "So they're a wonderful diversification tool."

The most popular pure-corporate bond ETF is LQD with some $3.6 billion in assets. But much of that is no doubt due to its early mover status. Its mid-2002 launch made it one of the first fixed-income ETFs on the market. But there's another option with similar characteristics.

The iShares Lehman Credit Bond Index (NYSE: CFT) has about the same duration as LQD at just north of six years. And its yield of 5.4% is within the same range as LQD's payout.

The two track very different benchmarks, however. In the case of LQD, it follows an index that includes the 100 most liquid issues. That's a lot fewer than the 3,300-plus bonds tracked by CFT's Lehman index.

"The two products offer exposure to two different segments of the investment-grade corporates market," said Matthew Tucker, head of investment strategy for fixed-income at Barclays Global Investors. "CFT captures the full market while LQD captures the more liquid segments of the market."

Long-term correlations between the two show not a lot of price performance difference. Tucker says that even though it's a much more concentrated fund, LQD's benchmark doesn't stray far from the broader market's sector weightings.

Quicker Response

"The bonds in LQD are generally larger and more heavily traded, so they tend to respond more quickly to market events," he added.

In down cycles, it's not uncommon to expect LQD to fall more. Likewise, when markets are strongly moving up, LQD tends to outperform. "Part of the situation is that less-liquid bonds don't always trade every day. That can result in a lag effect in tracking short-term bond performances," Tucker said. "But over time, both indexes tend to move very similarly."

BGI also breaks the broad Lehman credit benchmark into different subsets. One of those is the iShares Lehman Intermediate Credit Bond Index (NYSE: CIU). The ETF focuses on just short- and intermediate-term bonds. It's currently yielding around 5% with an average duration of 4.3 years.

"It tends to have a lower yield than CFT," Tucker said. "But it has less sensitivity to market changes and interest rates."

CIU launched last January along with CFT and another purely investment-grade corporate ETF, the iShares Lehman 1-3 Year Credit Bond Index (NYSE: CSJ). The shortest-term portfolio of its kind, CSJ has a duration of 1.9 years and now yields around 4.3%.

"These are the only pure investment-grade corporate bond funds we've seen so far on the market," said Romey, the portfolio manager. "They really give us some interesting options to broaden individual bond allocations depending on different appetites for risk."

Comments

[richjoy]

Thanks, quite timely for me, as I had recently gotten out of Treasurys. I'll give LQD a good look.

[JohnB]

Thanks for the substantial and worthwhile article.