LQD: Tread Cautiously Amid Rallying Investment Grade Bonds

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About: iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD)
by: Sankalp Soni
Summary

The LQD ETF is up 4.49% from its 52-week low in November 2018.

Interest rate risk is diminishing amid an increasingly dovish Fed, which is making high duration bonds increasingly favourable again.

As global economic conditions continue to worsen, the risk of BBB-rated bonds turning into fallen angels is also growing.

The iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD) is up 4.49% from its 52-week low few months ago. This comes amid an increasingly more dovish Fed, which is allowing fixed-income security prices to move higher. While there are certain good reasons to buy into investment grade bonds lately, investors should tread cautiously amid a backdrop of weakening economic conditions.

Source: Yahoo Finance

Prospectus Review

The LQD ETF aims to track the investment results of the Markit iBoxx USD Liquid Investment Grade Index. The fund seeks to provide investors exposure to the highest-quality corporate bonds that are considered investable, allowing investors to earn higher yields in comparison to government bonds. It has an annual net expense ratio of 0.15%, which is lower than the 0.17% average net expense ratio of all the ETFs that offer exposure to corporate bonds, thereby making it comparatively cost-effective as an investment vehicle.

The top 10 holdings of the ETF include:

Source: ishares.com

Risk Note from LQD prospectus:

The Fund may be subject to tracking error, which is the divergence of the Fund’s performance from that of the Underlying Index. Tracking error may occur because of differences between the securities and other instruments held in the Fund’s portfolio and those included in the Underlying Index.

It is worth noting that the fund’s strategy involves only holding corporate bonds that have maturities of three years or more, its portfolio has an average maturity of 12.57 years. The fund’s preference for longer weighted bonds makes it more susceptible to interest rate risk.

The LQD ETF has the highest amount of Assets Under Management, at $30.48 billion, among its peers of corporate bond ETFs, according to data from ETFdb.com. This makes it one of the most highly traded and liquid ETFs, which is the main reason I have chosen this ETF, as liquidity is essential. Moreover, it has an average daily trading volume of 7.97 million, whereas the next two largest corporate bond ETFs, Vanguard Short-Term Corporate Bond ETF (VCSH) and Vanguard Intermediate-Term Corporate Bond ETF (VCIT), have an average volume of 1.47 million and 1.25 million, respectively. The higher an ETF’s trading volume, the easier it is to buy and sell the ETF in the market. Thus, given my bearish thesis on this ETF, high liquidity is important for investors to be able to easily sell out of their positions.

Dovish Fed = diminishing interest rate risk

During Q4 2018, the LQD ETF witnessed a $3.728 billion net capital outflow amid fears of an overly hawkish Fed and a potential recession on the horizon. Nevertheless, since the start of this year, $1.548 billion has flowed back into the ETF, and dovish guidance from the Federal Reserve has played a large role in driving capital towards investment grade bonds.

On Jan. 30, 2019, Powell confirmed that interest rates hikes are now on hold amid a slowing economy and rising cross-currents from across the globe, as he stated, “the case for raising rates has weakened somewhat.” This has encourage market participants to expect no rate hikes at all this year, which in essence has eliminated interest rate risk for investment grade bonds.

This dovishness has triggered a risk-on rally, whereby investors are now allocating more capital towards high duration bonds. Duration is a measure of interest rate sensitivity, whereby the greater the duration, the higher the interest rate risk, and the greater extent to which bonds can face capital losses in rising interest rate environments. Given that the LQD ETF has a relatively high duration of 8.30, it faced significant downward pressure last year as the Fed hiked 4 times. Nevertheless, given that markets no longer believe the Fed will be hiking this year, high duration bonds are becoming more favorable again amid diminished interest rate risk.

Risk of fallen angels

While a dovish Fed has helped support investment grade bond prices higher, investors should beware that economic conditions are still slowing, and that chances of a recession in about a year’s time are still present. In fact, the CME Group’s FedWatch tool is currently exhibiting a 24.3% chance of a rate cut in January 2020. This is reflective of how futures traders and market participants are still anticipating a recession, or at least worsening economic conditions ahead, which would warrant monetary policy easing from the Fed.

Note that the LQD ETF currently holds 48.53% exposure to BBB-rated bonds, which means almost half of the fund’s portfolio consists of the lowest-rated investment grade bonds. This exposes the fund to the risk of "fallen angels," where BBB-rated bonds are downgraded to junk bond status amid worsening economic conditions undermining their ability to service debt. This would lead to large-scale capital losses for the LQD ETF as underlying bonds plummet in value, and yields jump. Therefore, given that both domestic and global economic conditions continue to slow, and chances of a recession remain present, it is not an ideal time to be holding exposure to investment grade bonds through the LQD ETF.

Chances of rate cuts increasing

Nevertheless, as economic conditions worsen, the probabilities of rate cuts from the Fed continue to rise. While high duration bonds incorporate higher interest rate risk during rising rate environments, they also offer more upside potential during declining rate environments. Hence, exposure to LQD could potentially be profitable once the Fed officially shifts from a rate hiking cycle to a rate cutting cycle.

Once the worst is over, which would be in the form of large-scale downgrades of BBB-rated bonds to junk status when economic conditions deteriorate further, it would then be a more attractive time to buy into the ETF. At his point, we would be mostly left with exposure to companies with high credit qualities (strong balance sheets/ effectively able to service debt). These bonds will then be able to offer upside price potential when the Fed begins its rate cutting cycle. Therefore, while it may not be an appealing time to buy into the ETF at the moment, I would certainly keep this ETF under consideration going forward.

Strategy

While high duration bonds have become favorable again amid an increasingly dovish Fed and diminishing interest rate risk, investors should beware of the downside potential from BBB-rated bonds turning into fallen angels, which would incur notable capital losses for the LQD ETF. I would recommend waiting until the worst of the anticipated economic pain/ credit downgrades are over. Thereafter, over the longer-term, investment grade bonds could witness more upside potential as we enter a new cycle of declining interest rates. Nevertheless, for now, I do not recommend holding exposure to the ETF.

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