ETF LQD: another year passes and corporate bonds remain difficult to justify
Main Thesis / Background
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. This fund has a declared objective “to track the investment results of an index composed of US dollar-denominated investment grade corporate bonds”.
I haven’t owned LQD for a long time, consistently giving it a “hold” rating as I’ve seen pros and cons, but not enough pros to justify buying it. In September 2021, this was still the case. In retrospect, this caution proved justified. LQD suffered a steep loss, despite an environment where stocks are also down:
Armed with this understanding, I wanted to revisit LQD again to assess whether I should improve my outlook heading into the new year. Upon reflection, I continue to see a balancing act for this sector idea. Corporate bonds have seen their value proposition improve slightly, but not enough for me to really feel comfortable owning this space. Accordingly, I will keep the “hold” rating in place and explain why in more detail below.
A buy case could be made for income
I’ll start this review with a look at one of the reasons an investor might want to buy LQD right now. This mainly has to do with the revenue story behind the sector. As readers are surely aware, 2022 has been a year of rising interest rates. While this has rattled debt and equity markets, the net result is that the income offered by fixed income securities has also increased. This makes sense, because as interest rates rise, the cost of borrowing rises. Although bad for borrowers, the next result is that lenders (or investors buying back the debt) may in turn earn a higher return. This is clearly reflected in the corporate bond yield curve, with current yields reaching a 12-year high:
The area of focus here is that those looking at the industry from an income perspective must like what they see to some degree. After years of yields of 3% (or less), IG corporate bonds are finally offering a reasonable income stream.
Fortunately, this is also reflected in LQD. The SEC yield (a short-term measure of fund performance) is 4.76%. This is partly due to the fall in the stock price (which drives up the current yield), but also because the distributions have increased.
It is a very strong development. Distributions are up year over year, with September distributions showing a 25% growth over February. It’s an impressive story. The conclusion for me is that a “sell” or bearish rating on this fund and this sector is not appropriate because the revenue growth is too strong. While I have other concerns, which I will address, the fact is that conservative investors who want a growing income stream with little credit risk might indeed find it in this option.
Net debt is down, limits credit risk
My next topic focuses on a trend that has been going on for some time. It’s that credit risk within the corporate bond space – especially IG companies – remains very low. While this hasn’t stopped the sector from posting losses, the main driver behind this has been rising interest rates (prices move inversely to yields). While this posed a real challenge for investors, the silver lining is that the underlying support within the sector itself has not deteriorated. The total return may be influenced by the underlying quality bonds themselves. In this vein, defaults and arrears have been low and credit rating upgrades have also increased. This has been consistent over the past two years and remains so to this day.
Personally, I believe this story remains intact for 2023 as well. Although concerns about economic growth have been in the headlines lately, the fact remains that US companies are well capitalized. It’s actually a global story too. Revenues and earnings have held up well, and available cash is high given the extent of corporate refinancing when interest rates have fallen. If we look at net debt ratios, we see that there is little risk that IG companies will meet their short-term financial obligations:
What I see here is a business environment where there is no major risk of credit space deterioration. Even in the case of junk debt, defaults have been rare since the start of the year. Until there is a significant regression in this sector, I won’t worry too much about IG credit. Considering that debt ratios are lower today than they were last year, this is a favorable environment.
So what is the problem?
As I mentioned above, there are legitimate reasons to buy IG corporate bonds, and LQD by extension. I haven’t seen a lot of buying opportunities in 2022, but I recognize that revenue and credits are more positive now than they have been in the past. This begs the question – why the reluctance to buy at these levels?
The answer to this question is a fundamental headwind that has plagued debt markets over the past year. These are rising yields and interest rates and, just as importantly, the prospect of continuously rise in short-term rates. This is important because IG corporate bonds are generally longer term in nature. This makes them more sensitive to interest rates. LQD reflects this, giving investors exposure to many long-term maturities. The impact is a duration level (a measure of interest rate sensitivity) greater than 8 years:
This means that LQD continues to be very exposed to rising interest rates. Despite the increase in the fund’s distribution rate, these duration levels mean that there is still significant downside risk. This income stream can be wiped out if interest rates rise another 0.5-1.5%. This is not an unrealistic prediction. In fact, markets are currently pricing in a 0.75 basis point move from the Fed when they meet later this month:
From my perspective, there is no denying that the Fed will continue to raise rates for now. While I personally think 2023 will be more dovish than the Fed expects, over the rest of 2022 there will still be quite a hawkish tone. More hikes are on the way, creating problems for high-duration funds like LQD.
Beating inflation requires taking more risk
As my followers probably remember, I’m exclusively into stocks right now, with the exception of municipal bonds. Municipal leveraged funds currently have competitive returns, especially on a tax-adjusted basis. While the duration risks are just as high as those of IG businesses, the credit quality is stronger and the tax savings offer a better risk-reward ratio in my opinion. This reality has caused me to walk away from LQD – essentially at the expense of what I consider to be better options.
In this vein, I want to illustrate that fixed income investors currently have a myriad of options. LQD’s revenue story is better than it was a year ago, which I covered at the beginning of this article. However, this trend is fairly consistent in the fixed income universe. While yields have risen and bond prices have fallen across most sectors, current yields are finally giving investors something to cheer about.
The caveat to this is that inflation remains hot. This means that on a real yield basis, bond investors are likely not keeping pace. To combat this backdrop, those interested in credit probably need to push the risk pedal a little more than what a fund like LQD will offer. For me, I prefer leverage in the IG muni space. But for those who are not interested in this strategy, there are other options. The natural place to start looking is high yield, as well as IG debt in emerging countries. As the chart below shows, the current spreads in these sectors are quite wide, especially when compared to IG US companies:
Now, I’m not saying these are the right investments for all readers. Quite the contrary. I am very transparent in my personal holdings (I keep them up to date on my profile page) and I am not exposed to these areas. So that should be revealing. But I’m not long LQD either. And the truth is, I see more value in high yield because of the wider credit spreads that provide high levels of income to offset inflation and interest rate risk. LQD is a much safer fund, but the truth is that investors won’t follow the cost of living if that’s what they choose to invest in. The good news is that there are higher yielding options, but readers should remember that they come with a bit more risk.
At the end of the line
LQD hasn’t gone anywhere fast over the past year. In fact, it’s too nice. He has gone somewhere, and that somewhere has broken down. Although the IG corporate bond sector was seeing underlying strength, limited delinquencies and some investor buying, the end result was that inflation and the Fed’s rate hike were too much to handle. I think the worst is over for LQD in the short term, but continued Fed rate hikes and stubborn inflation are limiting any upside we are likely to see in the short term. Therefore, I must maintain my “hold” rating on LQD and suggest that readers approach this fund very selectively as we approach Q4 and 2023.