This post is the latest in an ongoing series introduced in the article Best Post-QE2 Opportunities Lie Beyond Stocks providing a detailed analysis on investment strategies outside of the stock market leading up to the end of QE2.
Investment Grade Corporate Bonds have been a remarkably consistent asset class for the last several years. And these steady results are likely to continue in the months ahead, particularly with QE2 coming to an end on June 30. As a result, investors should be well served to either maintain current positions or establish new positions in Investment Grade Corporate Bonds.
Investment Grade Corporate Bond performance has been impressive since the early days of the financial crisis. Investment Grade Corporate Bonds, which represent higher quality bonds that are rated BBB/Baa or higher by the major credit rating agencies, experienced a sharp drop like nearly everything else at the onset of the crisis, plunging -17% in the first ten trading days following the collapse of Lehman Brothers.
But after setting a bottom in late September 2008 and stabilizing over the next few months, Investment Grade Corporate Bonds entered into a rally that has been rewarding from both a capital gains and income perspective. Moreover, these gains have also come with hardly any meaningful volatility along the way.
For example, the iShares iBoxx $ Investment Grade Corporate Bond Fund (NYSEARCA:LQD), which is by far the largest exchange traded fund available for this category, has generated an overall return of nearly +60% in the 2+ years since bottoming in late 2008. And the lack of volatility since the crisis speaks for itself in the chart below. Click to enlarge:
A variety of factors support the positive outlook for Investment Grade Corporate Bonds. These are listed below.
1. Companies Flush with Cash
First, investment grade companies are flush with cash that is at near record levels on their balance sheets. Still smarting from the days following the financial crisis when emergency credit lines that were in place for such a catastrophic episode were unexpectedly pulled, companies appear more inclined to maintain this extra buffer of protection on their own books, particularly as various global risks still remain far from resolved over two years later. This bodes well for the holders of investment grade corporate bonds, as most companies stand ready to continue to make payments to debtholders even during more turbulent economic times.
2. Consistent Performance with Low Correlation to Stocks
Investment Grade Corporate Bonds have demonstrated a favorable returns relationship relative to stocks. To begin with, investment grade corporate bonds have traded independently of stocks since the financial crisis, as the returns correlation between the two asset classes is a low +0.20. Just as notable has been the relationship of these returns. Investment grade corporate bonds have generally risen when stock markets were rising over the last two years, which is positive. But they’ve held up just as well when stocks were falling, which is important from a portfolio diversification perspective. For example, Investment Grade Corporate Bonds as measured by the LQD gained +24% from the March 9, 2009 stock market bottom to the end of QE1 on April 26, 2010. But when the stock market as measured by the S&P 500 entered into a -14% correction during the QE Pause from April 26, 2010 to August 26, 2010, the LQD rose by another +8%. And during the QE2 stock market rally in the days since, the LQD has added another +2%. Thus, investment grade corporate bonds have provided consistently positive returns along with favorable portfolio diversification benefits. Click to enlarge:
3. Strong Technicals
Investment Grade Corporate Bonds have behaved very well from a technical perspective over the last 2+ years. Returning to the LQD, it has found consistent support at its various moving average levels. For example, it has had extended periods of finding support at its 20-day moving average during uptrends, has found consistent support at its 50-day moving average during any short-term pullbacks and more recently has found strong support at its 200-day moving average since December 2010. Currently, the LQD is essentially at its 20-day moving average and above its 50-day and 200-day moving averages by a solid margin. Click to enlarge:
4. Reasonable Valuations
Investment Grade Corporate Bonds remain reasonably attractive from a valuation standpoint. Using the LQD, the average credit rating in the Fund is a BBB+. An examination of the equivalent Baa yields within the investment grade credit universe reveals that they remain comfortably within the downward sloping channel that began over 20 years ago (yields go down, prices go up). Of course, some day yields will reverse and head higher for this asset class, but there is no reason to think that such a trend reversal is going to happen in the coming months with the end of QE2 looming and the economy showing signs of weakening. Click to enlarge:
Yield spreads relative to U.S. Treasuries also remain attractive. While they have narrowed significantly since the early days of the financial crisis in 2008, at roughly 2% they remain well above pre-crisis levels at just above 1%. Click to enlarge:
5. Economic Outlook and the End of QE2
Recent economic trends favor the performance outlook for the high quality bond category. Investment Grade Corporate Bonds have historically performed well during periods of economic weakness due to the defensive characteristics of the asset class. The fact that U.S. economic data has been deteriorating for the last several months suggests the potential for a rotation by investors out of higher risk assets like stocks and commodities into the relative stability of Investment Grade Corporate Bonds. This likelihood is compounded by the fact that the end of QE2 is soon to arrive on June 30. Since economic growth appears unlikely at this point to accelerate to support stock and commodity prices inflated by QE2, the potential for a repeat of the post QE1 period marked by a sharp correction in stocks and commodities and a rise in Investment Grade Corporate Bonds is possible if not likely.
All of these factors support Investment Grade Corporate Bonds as an attractive investment opportunity for the months ahead. As mentioned throughout this post, the iShares iBoxx $ Investment Grade Corporate Bond Fund (LQD) provides an ideal way to gain a broadly diversified exposure to the investment grade corporate bond market in a single investment instrument. Overall, the LQD contains 653 bond holdings as of June 2, 2011.
The fact that LQD trades on an exchange is also a key advantage, as it overcomes the obstacle associated with individual corporate bond securities that mostly trade in decentralized markets with limited price transparency throughout the trading day. By using the LQD, you have a security that trades with price transparency and high liquidity throughout the trading day.
I first purchased positions in LQD on November 5, 2008 in the days following the outbreak of the financial crisis and I have held a meaningful position ever since. In the current environment, I have been using short-term pullbacks to incrementally add to LQD positions ahead of the end of QE2.
An important risk is worth noting about LQD or any other Investment Grade Corporate Bond ETF in the current environment. While this asset class has performed well during market rallies and is set to post further gains during economic and stock market pullbacks, it is not necessarily conditioned to withstand another full-blown crisis episode similar to the Lehman event back in late 2008.
This is due to the composition of the Investment Grade Corporate Bond market. Using the composition of the LQD as an example, banks represent by far the largest sector allocation at 27.82% as of June 2, 2011. And leading company specific exposures ranging from 2.5% to 3.0% each of the entire portfolio include Bank of America (NYSE:BAC), Citigroup (NYSE:C), GE Capital (NYSE:GE), Goldman Sachs (NYSE:GS), JP Morgan Chase (NYSE:JPM), Morgan Stanley (NYSE:MS) and Wells Fargo (NYSE:WFC). Thus, if events were to unfold where we found ourselves once again on the precipice of another major financial crisis – the current situation in the euro zone comes to mind – a meaningful pullback in any Investment Grade Corporate Bond ETF including the LQD should be expected. As a result, investors would be well served to have a strategy to exit positions in advance if events began to unfold in this direction.
Investment Grade Corporate Bonds present an attractive investment opportunity in the current environment. The asset class has been a solid performer over the last several years, and this trend is likely to continue in the months ahead including in the post QE2 market environment.
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.