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Reconsidering High-Grade Corporate Bond ETFs

July 9, 2018 11:00 am
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Corporate bond exchange traded funds, both of the investment-grade and junk varietals, are struggling this year — and investors are growing impatient. 

The iShares iBoxx $ Investment Grade Corporate Bond ETF (NYSE:LQD), the largest investment-grade corporate bond ETF, and the iShares iBoxx $ High Yield Corporate Bond ETF (NYSE:HYG), the largest junk bond ETF, rank seventh and eighth among all U.S.-listed ETFs in terms of assets shed this year.

What Happened

Amid rising bond market uncertainty, some market observers believe investment-grade fare is the way to go.

“Investment grade bonds typically outperform their high yield counterparts when uncertainty rises, given their higher quality and lower default risks,” BlackRock said in a recent note.

Widening spreads relative to Treasuries are hampering corporate bonds this year, but investment-grade issuance is soaring.

Investment-grade issuance has risen amid a jump in M&A activity, particularly in the media segment, according to BlackRock. 

Why It's Important

The $33.29-billion LQD, which holds over 1,900 bonds, has a 30-day SEC yield of 4.13 percent, well above the yield on 10-year Treasuries.

LQD's effective duration of 8.49 years could be a concern for some investors at a time when interest rates are rising.

The actively managed iShares Interest Rate Hedged Corporate Bond ETF (NYSE:LQDH) is an option for investors looking to trim duration risk. LQDH holds LQD with short positions in Treasury swaps to lower rate risk. LQDH's 30-day SEC yield of 3.28 percent is obviously lower than LQD's, but the former's effective duration is just 0.2 years.

What's Next

Bond investors should monitor developments on the short-term rate front for possible clues about the viability of investment-grade bonds going forward.

“Higher short-term rates may be here to stay, but we expect quality exposures to reassert their typical resilient nature following the recent surge in actual, and expected, IG issuance,” said BlackRock.

“We view the recent uptick as a temporary supply shock. It partly reflects a shift in issuance expectations after a mega media merger was given the green light. Yet for IG underperformance to persist, we would need to see a sustained rise in issuance expectations.”

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