- LQD has been a terrific equity hedge so far in 2020, and it has beaten the broader bond and equity markets since my buy recommendation.
- Despite bullish momentum, the Fed's decision to lower rates may leave fewer potential tailwinds going forward.
- LQD has quite a high duration, and investors have been shedding longer-term bond exposure in recent weeks.
The purpose of this article is to evaluate the iShares iBoxx $ Investment Grade Corporate Bond ETF (NYSEARCA:LQD) as an investment option at its current market price. Earlier this year, I noted how I found LQD's outlook attractive, and recommended investors obtain some exposure for a few reasons. One, I saw a macro environment favoring quality bond assets and two, I believed equity markets were a bit too frothy.
In hindsight, this thesis has proven correct, as LQD has had a terrific start to 2020 and equity markets have indeed come under pressure. Looking ahead, I see a challenging market for equities, and continue to believe investors should focus on fixed-income sectors for diversification. However, given LQD's move higher in the short-term, I am advocating a more cautious stance. Specifically, I believe the recent Fed action has now removed an important catalyst for bond funds as it is now priced in. This could limit upside potential from here. Additionally, investors are limiting their duration risk right now, which is especially important if the Fed does not plan to lower rates further. With investors beginning to rotate out of longer term bonds, this could eventually trickle down to LQD, which has an effective duration above nine years.
First, a little about LQD. The fund's stated objective is "to track the investment results of an index composed of U.S. dollar-denominated, investment grade corporate bonds". LQD is currently trading at $133.27/share and yields 3.06% annually. When I covered LQD in January, I had a bullish outlook on the fund. While I did like the fund, much of this was also driven because I felt equity prices were ripe for a correction, and I had been advocating fixed-income products as a hedge. In hindsight, this was a good call, as LQD has seen a nice return since then, while the broader market has come under quite a bit of pressure, as shown below:
Source: Seeking Alpha
While LQD would have definitely served investors well in the short-term, and I believe it could be a useful hedge going forward, the recent run-up in price has me revising my expectations for the fund. Simply, I don't expect such a generous short-term return to continue from here, so I am shifting to a more "neutral" outlook for the fund, and I will explain why in detail below.
LQD Is Beating Broad Benchmarks
To begin, I want to take a look at how LQD has been performing in 2020. As I noted, this was a fund I felt was set to perform well this year, but I have still been quite impressed at the alpha the fund has generated. As investors have looked to take some risk off the table, investment grade corporates are handily beating out alternative asset classes. While this is a sector that would normally lag other options, due to its more conservative nature, investors may be surprised to see LQD actually leading the broader bond index, and even equities. To illustrate, consider the year-to-date return of LQD against the iShares iBoxx $ High Yield Corporate Bond ETF (HYG), the iShares Core U.S. Aggregate Bond ETF (AGG), and the S&P 500, as shown below:
Clearly, this is an attractive graph for LQD, and it shows the fund is working as intended. When equities sold off, this has pressured high yield corporates, yet investment grade corporates performed well. Simply, this means the market is working as it should, rewarding investors who rotated to quality bonds when the risk-off trade began to dominate.
Looking ahead, an environment does still exist where LQD could perform well. While the rising share price has pressured the yield down just over 3%, this income stream remains attractive. Consider that treasury yields have also been on the decline, which means the yield spread offered by LQD has stayed constant even as the share price rose. In fact, treasury yields are back to sitting at some of their lowest levels in a generation, as shown below:
My takeaway here is investors in LQD have bullish momentum and an attractive yield spread over treasuries with a similar duration. Therefore, I do see merit to continuing to hold this investment, which helps explain why I am not "bearish" on the fund. However, for the reasons I will detail below, I am tempering my expectations, which has lead me to suggest a "neutral" outlook is more reasonable from here.
Investors Are Re-thinking Duration Risk
To begin, one of the primary concerns investors may have with LQD, and many alternative bond funds right now, is duration risk. This is the risk that an investment will be negative impacted by rising interest rates. The bonds, and funds that hold them, that have longer dated maturities and durations will be more heavily impacted by rising rates.
Of course, investors may not be too concerned about rising rates right now. After all, the market began to price in a Fed interest rate cut, which was expected to come in their March meeting. However, the Fed surprised markets with a .50 basis point cut on March 3rd, well ahead of their meeting. While the initial impact was positive for equities, they declined steadily throughout the day (on 3/3), while bond funds like LQD rose. Clearly, lower rates are positive for fixed-income products, and holding LQD turned out to be profitable indeed.
However, my concern now rests with where we go from here. With the Fed already acting, they have a much more limited scope on how they can address future economic concerns. If the impact of the coronavirus begins to level off, or economic growth comes in better than expected, it would stand to reason the Fed might reverse these cuts and send interest rates higher. In fact, even before the cut this past week, markets were beginning to make tactical moves to protect themselves from rising rates.
To illustrate, consider weekly inflows in to 20-year treasury bonds. At the end of February, even before the Fed cut, investors were beginning to exit this sub-sector to limit their duration risk, as shown below:
The reason behind this move is that longer term bonds are only offering slightly more in income compared to shorter-term maturities. While the higher yields are still attractive, the risk for earning that extra yield is substantial if investors are predicting higher rates in the future. Therefore, it appears some investors were content to lock in some profit on longer-term assets, and shift to those with a shorter time-frame. Whether this trend will continue or not is something we will have to wait and see to find out, but it does suggest retail investors should simultaneously be thinking about their own risk tolerance.
And this is an important consideration for LQD. While I noted the fund is yielding 3%, which is more than short-term treasuries, we do have to consider that LQD is an ETF with long-term assets in it. In fact, the majority of the bonds in the portfolio have maturities of seven years or more, as seen below:
As you can see, this is a fund with an intermediate term to long term slant, and it has an effective duration above nine years. The takeaway here is investors need to appreciate the duration risk they are taking on by investing in this investment. Of course, this is not inherently "bad", as LQD has been performing well and its extra yield has indeed piqued investor interest so far in 2020. However, based on recent fund flows, it appears there may be some changing sentiment in the market regarding longer term bonds, and investors may want to re-evaluate their own positions to cope for the possibility of that activity continuing going forward.
Defaults Are Still Rare, But Credit Risk Has Increased
My final point concerns the broader investment grade corporate bond market, and how it relates to LQD specifically. As investors are likely aware by now, investment grade bonds have seen a surge of issuance over the past decade, as companies have rushed to lock in a tremendous amount of debt at historically low rates. While piling on debt does make the landscape inherently more prone to credit risk, defaults in the investment grade space have still been rare. However, there are growing risks in the sector that investors need to be aware of.
First, it is important to point out that the growth in investment grade corporate bonds has largely been driven by issuance rated BBB. While this is an investment grade rating, it is the lowest level. Worryingly, this rating type now makes up more than half the amount of outstanding investment grade corporates in the market today, as shown below:
Source: Charles Schwab
As you can see, this graph pretty clearly shows how the investment grade landscape has changed over the years. Further, this trend has made its way in to LQD. While the fund still holds a slightly higher percentage of A-rated bonds or better, BBB-rated bonds are almost evenly weighted, as shown below:
My point here is this is a development investors need to keep a keen eye on. While investment grade defaults have still been rare, historically and post-recession, this changing make-up could test that history if another recession occurs. In fact, Moody's has raised similar concerns, advising in a research report last month that they expect BBB-rated companies to fuel the next default cycle. The logic behind this was concern over the half a trillion in outstanding debt within that rating category (at the end of 2019), which is up substantially from just two years ago.
My takeaway here is not to be alarmist. I do not expect widespread defaults in the investment grade corporate sector, including in the BBB-rated space. Interest rates were just cut, and U.S. corporate earnings have generally been steady, especially outside the Energy sector. However, after the impressive run LQD has had, I believe it is a smart time to take stock of the risks facing the fund, and to be weary of adding to positions at these levels.
The market has shifted from "risk on" to "risk off" in a dramatic fashion. This has benefited LQD, and the investors who hold it, as the fund has moved steadily higher while many other investment plays have produced negative returns. While I believe LQD could remain an effective hedge in the months to come, I would caution investors from getting too optimistic at these levels. LQD is at a high price based on its own trading history, and the risks brewing in the corporate debt markets could signal pain ahead. While investment grade corporates remain one of the safest fixed-income sectors in the market today, duration risk is also quite high, which means investors are not earning much in terms of extra income to compensate for the risks they are taking. Therefore, I believe a "neutral" rating is now appropriate for LQD, and recommend investors carefully consider positions at this time.
This article was written by
I began my career in financial services in 2008, at the height of the market crash. This experience has shaped my investment strategy - which is focused on diversification, dividends, and growth opportunities. I am a competitive tennis player, and I competed at the Division I level in undergrad. I have a Bachelors and MBA in Finance.(He is a contributing author for the investing group CEF/ETF Income Laboratory where he specializes in macro analysis. Features of CEF/ETF Income Laboratory include: managed income portfolios (targeting safe and reliable ~8% yields) making use of high-yield opportunities in the CEF and ETF fund space. These are geared toward both active and passive investors of all experience levels. The vast majority of holdings are also monthly-payers, for faster compounding and steady income streams. Other features include 24/7 chat, and trade alerts. Learn more.)
Analyst’s 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.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.