LQD: Investment grade bond ETF, excessive interest rate risk, yield below 3.3%

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cagkansayin

Author’s Note: This article was released to members of the CEF/ETF Income Laboratory on October 26.

I last covered the iShares iBoxx $Investment Grade Corporate Bond ETF (NYSEARCA:LQD), an investment-grade corporate bond index ETF, in early 2022. In In that article, I argued that LQD’s low dividend yield and excessive interest rate risk made the fund a below-average investment, one that would significantly underperform if rates were to rise. Since then, rates have rose, and the fund significantly underperformed, as expected.

LDQ

Previous LQD article

Although conditions have changed significantly in recent months, LQD remains a sub-par investment opportunity, for several reasons.

The fund’s interest rate risk remains excessive, and is of particular concern as inflation remains high and interest rates continue to rise.

The fund focuses on long-term bonds, which yield almost as much as short-term bonds, with significantly higher risk.

The fund’s investment-grade bonds generally yield less than riskier lower-grade bonds, but the spreads are much wider than average.

LQD remains a below average investment opportunity, so I would not invest in the fund at this time.

LQD – Basics

  • Investment Manager: BlackRock
  • Underlying Index: Markit iBoxx USD Liquid Investment Grade Index
  • Expense ratio: 0.14%
  • Dividend yield: 3.26%
  • Total returns 10-year CAGR: 1.3%

LQD – Overview and Benefits

LQD is a high quality corporate bond ETF. It is the largest fund of its type on the market and the industry benchmark. LQD tracks the Markit iBoxx USD Liquid Investment Grade Index, an index of these same securities. This index includes all dollar-denominated corporate bonds from issuers in developed countries with a superior credit rating (BBB or better). Relevant securities must also meet a basic set of liquidity, size and trading criteria. It is a market capitalization weighted index with a 3% issuer cap.

LQD offers broad exposure to investment grade bonds, with investments in over 2,500 of them, across all relevant industry segments.

LDQ

LDQ

LQD focuses on securities that are relatively safe, with strong credit ratings, an average of A/BBB, and low credit risk and default rates.

LDQ

LDQ

LQD’s safe and diversified holdings reduce risk, volatility and potential losses during downturns and recessions. Expect relatively small losses during the latter, as was the case in 1Q2020, at the start of the coronavirus pandemic. On the other hand, the fund underperforms against Treasuries during these periods, due to a lack of flight to quality effect.

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Data by YCharts

LQD is currently yielding 3.3%, a relatively low amount. Although the fund’s dividends are low at present, dividends will almost certainly see strong growth in the coming months, due to the Federal Reserve’s interest rate hike. LQD currently sports an SEC yield, a standardized measure of short-term revenue generation of 5.9%. Thus, fund dividends should reach around 5.9% in the months and years to come, at least assuming that interest rates remain high. LQD’s dividends are already growing strongly, rising more than 27% year-to-date, equating to a 0.7% increase in yields.

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Data by YCharts

LQD offers investors a rapidly growing return of 3.3%, at a low level of credit risk. While this is a reasonably compelling value proposition, it is more than offset by the risks and downsides of the fund. Let’s take a look at these.

LQD – Risks and Disadvantages

Excessive interest rate risk

LQD focuses on high quality corporate bonds. These securities have very long maturities, the private issuers having issued a plot long-term debt from 2020 to 2021, when interest rates were at their lowest. Conditions have changed significantly since then, but the indebtedness remains, at least for several more years.

Due to the above, LQD focuses on securities with relatively long maturities and interest rate risk, with an average duration of 8.1 years. Investors should expect capital losses of around 8.1% for every 1.0% increase in interest rates, a very large amount and somewhat higher than its peers.

LQD duration

Fund deposits – Table by author

LQD’s high duration means the fund is likely to underperform when interest rates rise, as it has since the start of the year. The fund’s performance was a little worse than expected, as the duration was even higher earlier in the year.

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Data by YCharts

LQD’s excessive interest rate risk has resulted in significant losses and underperformance in the past, and could lead to further losses if interest rates continue to rise/rise more than expected. This is an obvious possibility, as inflation remains elevated and the Federal Reserve remains committed to continuing to raise interest rates. These are most already priced in, but could occur if inflation persists longer than expected, requiring higher interest rates for a longer period. Inflation has persisted longer than expected, so this is a very real risk.

LQD’s high interest rate risk is a significant negative factor for the fund and its shareholders. In my view, this is a break in the current economic and market conditions, and will remain so until inflation normalizes and the likelihood of an interest rate hike diminishes.

Term premiums are low

Long-term bonds present a higher interest rate risk. In compensation, long-term bonds tend to offer investors higher interest rates, and therefore dividends. Even though it is in general the case, there are exceptions, and we are currently in the middle of one.

Soaring inflation has driven up interest rates across the board, but some interest rates have risen more than others. Short-term interest rates have risen sharply as investors expect large and aggressive hikes from the Federal Reserve in the near term. Long-term interest rates, on the other hand, rose more modestly, as investors expect these increases to be transitory and for interest rates to normalize in the coming years. As a result, long-term rates are roughly equal to, and sometimes lower, short-term rates. For example, the rates for 7-year Treasury bills, which are closest to the average maturity of LQD, are 0.45% lower than the rates for 2-year Treasury bills. The spreads are well below their historical average and the lowest in more than a decade.

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Data by YCharts

Long-term bonds have higher interest rate risk than short-term bonds and yield less in addition. Under these conditions, long-term bonds are significantly inferior to short-term bonds, in my opinion at least. LQD focuses on long-term bonds and therefore shares the same problems and shortcomings as said asset class.

Credit spreads are wide

LQD focuses on higher quality bonds. Because these securities have high credit ratings and default rates, interest rates and yields are low. High yield bonds are the opposite, with low credit ratings, high default rates, but high interest rates and yields. Although high yield bonds (almost) always yield more than investment grade bonds of comparable maturities, spreads have widened in recent months, and are at historically above-average levels.

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Data by YCharts

Widening credit spreads mean that high yield bonds offer relatively high yields, making them much more attractive investment opportunities. Risks are higher too, but the potential rewards are even higher, and higher than they have been in the past. Under these conditions, I would choose high yield corporate bonds over comparable investment grade bonds. The SPDR Portfolio High Yield Bond ETF (SPHY) is a particularly simple and solid high yield corporate bond index ETF, with a yield of 6.3% and a better overall investment than LQD, at least in my opinion.

Conclusion

LQD is a simple, high-quality bond index ETF. LQD carries excessive interest rate risk and yields relatively little. As such, I would not invest in the fund at this time.

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