Author's note: This article was released to CEF/ETF Income Laboratory members on January 30th, 2022.
The iShares iBoxx $ Investment Grade Corporate Bond ETF (NYSEARCA:LQD) is a broad-based investment-grade corporate bond index ETF. LQD's holdings are of reasonably good quality, and the fund tends to perform reasonably well during downturns and recessions. On the other hand, the fund offers investors a paltry 2.4% dividend yield, and with a duration of 9.2 years, should see significant losses if rates were to rise, which seems likely. LQD is a high-risk low-reward investment opportunity, and so I would not be investing in the fund at the present time.
LQD is the largest investment-grade corporate bond index fund in the market, acting as an industry benchmark. The fund is administered by BlackRock, the largest investment managers in the world.
LQD tracks the Markit iBoxx USD Liquid Investment Grade Index, a broad-based investment-grade corporate bond index. It is a relatively simple index, including all dollar-denominated corporate bonds from developed country issuers with investment grade credit ratings (BBB or higher). Applicable securities must also meet a basic set of liquidity, size, and trading criteria. It is a market-cap weighted index, with a 3% issuer cap.
LQD is a well-diversified fund, with investments in 2,494 different bonds, and with exposure to most relevant industry segments. Concentration is quite low too, with the fund's top ten issues accounting for just 22% of the value of the fund. Diversification reduces risk and volatility, and effectively prevents the possibility of significant losses or underperformance from any one corporate bankruptcy or default.
LQD focuses on investment-grade corporate bonds, with a median credit rating of BBB. This is a reasonably good rating, indicative of reasonably strong companies, with good balance sheets and financials. Risk and default rates are both quite low. Credit ratings are as follows.
LQD's holdings are reasonably safe, which should lead to reasonably strong performance even during tough economic conditions. Expect relatively low losses during downturns and recessions, somewhere between those of treasuries, the safest fixed-income securities, and high yield corporate bonds, the riskiest. This was the case during 1Q2020, the onset of the coronavirus pandemic, and the most recent downturn.
To summarize, LQD offers investors diversified exposure to investment-grade corporate bonds, relatively safe securities. Although the fund seems like a reasonable investment opportunity for more risk-averse investors and retirees, it suffers from two serious flaws. Let's have a look at these.
LQD currently sports a paltry 2.4% dividend yield, paired with an excessively high duration of 9.2 years. Income and prospective returns are quite low, while interest rate risk is quite high, a dreadful combination. Before taking a closer look at these two metrics, I want to explain how they came to be, as I think doing so will help us understand the issues facing the fund.
Let's use AT&T (T), the fund's sixth-largest issuer, as an example.
AT&T is one of the largest telecommunications companies in the U.S., with several business lines, tens of millions of customers in dozens of customers, and a growing subscriber base. It is also one of the most indebted corporations in the country, with over $150 billion in net debt. Debt is high considering the company's financials and assets, with a debt to EBITDA ratio of 3.7x, and a debt to equity ratio of 1.0x. These are not great figures, although they could be worse.
AT&T is also a reasonably safe, strong company, with an adequate capacity to meet its financial obligations because, well, because the credit rating companies say it is, and have rated the company's debt as BBB.
Notwithstanding the above, AT&T's massive debt pile and attendant interest expenses have been a perennial negative and risk for the company and its shareholders. Debt is costly and must be paid back, in full, at maturity. Cash spent servicing and paying back debt is cash which is not used to invest in the business, which jeopardizes a company's growth and future. Excessive debt is bad, and AT&T is excessively indebted.
Then came the pandemic, and attendant policy response. The Federal Reserve slashed rates to zero, and embarked on a massive quantitative easing program. These centered on corporate bond purchases, including directly purchasing LQD. Interest rates tumbled down, especially of those securities which saw direct Federal Reserve intervention, including investment-grade corporate bonds.
AT&T took advantage of the above, by refinancing about half of its total debt load with more favorable conditions, in 2020-2021. Interest rates went down, maturities went up. The company effectively locked in the lowest interest rates in a generation for its massive debt pile for decades. Investors went along because, well, what choice did they have. Treasuries had even lower yields, as did other low-risk assets like CDs, money market funds, and the like. Higher-risk assets had higher yields and prospective returns, but risks were materially higher too, and economic conditions were still uncertain. Long-term investment-grade corporate debt made sense, especially considering the implicit Federal Reserve backstop.
LQD itself holds about $760 million of AT&T debt, and the conditions are quite good for AT&T. Most debt was issued after 2020, and so benefit from the above. Debt carries an average coupon payment of 3.8%, with an average maturity of 18 years. Conditions are favorable to A&T, not so favorable to LQD or its shareholders, but it was the best the market offered at the time.
By late 2020 the Federal Reserve had paused its investment-grade corporate bond purchases. By mid-2021, it was selling its holdings. By late-2021 it was signaling imminent rate hikes. Suddenly, loaning money to AT&T at 3.8% for 18 years looked unappealing. Investors sold AT&T debt. Bond prices went down by about 8.0%, as per LQD filings. Capital losses exceeded coupon rate payments, and so investors, including LQD, are underwater in their investment, so far at least.
LQD is now stuck with hundreds of millions worth of low-yielding, underperforming AT&T bonds. Prospective returns are quite low, as the bonds only yield 3.8%. Risks are high, as the bonds should see further capital losses if interest rates were to increase. LQD is stuck with these bonds for about 18 years, a very long time. If you invest in LQD, you'll be stuck with these bonds too, and although you can always sell your investment in LQD, you might be forced to sell at a loss if interest rates continue to increase. In my opinion, this is self-evidently an incredibly negative situation, and so I would not be investing in LQD at the present time.
Circling back to the metrics, LQD offers investors a paltry 2.4% dividend yield, and an excessively high duration of 9.2 years. The fund's dividend yield is quite low on an absolute basis, and the lowest yield in the fund's entire history. LQD offers investors little in income or prospective returns, a significant negative for the fund and its investors. As explained with AT&T, the fund's low dividend yield is the result of Federal Reserve policy. The fund might be a buy once policy shifts, but that has yet to happen.
LQD also sports a duration of 9.2 years. Duration is a measure of interest rate sensitivity and risk. A 1% increase in interest rates should lead to 9.2% in capital losses, and vice versa. LQD has a higher duration than most of its peers, in large part as corporations took advantage of historically low interest rates to issue long-term debt at favorable rates. LQD's duration is moderately higher than that of most of its peers.
LQD's above-average duration should cause the fund to underperform relative to its peers when rates are rising, as has been the case YTD.
LQD's above-average duration increases risks, and is particularly harmful when interest rates are rising, as is currently the case. In my opinion, under current circumstances investors should be avoiding funds with excessive duration, and that means avoiding LQD.
LQD is an investment-grade corporate bond index ETF. LQD offers investors a paltry 2.4% dividend yield, and could suffer significant losses if interest rates continue to increase. LQD is a high-risk low-reward investment opportunity, and so I would not be investing in the fund at the present time.
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This article was written by
Juan has previously worked as a fixed income trader, financial analyst, operations analyst, and economics professor in Canada and Colombia. He has hands-on experience analyzing, trading, and negotiating fixed-income securities, including bonds, money markets, and interbank trade financing, across markets and currencies. He focuses on dividend, bond, and income funds, with a strong focus on ETFs, and enjoys researching strategies for income investors to increase their returns while lowering risk.
I provide my work regularly to CEF/ETF Income Laboratory with articles that have an exclusivity period, this is noted in such articles. CEF/ETF Income Laboratory is a Marketplace Service provided by Stanford Chemist, right here on Seeking Alpha.
Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such 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.