Rising interest rates are making many bond fund investors nervous about the prospects for weakening future returns and unstable risk dynamics. This fear is putting some fuel behind ETF strategies that short Treasuries or sectors such as bank loans that have historically performed well in a rising rate environment.
The PowerShares Bank Loan Portfolio (BKLN), which invests in a basket of floating rate notes and senior loans, has accumulated more than $2.4 billion since the U.S. election. That confidence has so far been rewarded with a steadily rising price trend versus the volatility that has pervaded most aggregate bond benchmarks.
Yet, in a surprising twist of irony, there remains strong conviction in more traditional fixed-coupon investment grade corporate bonds as well. The iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD) has accumulated $3.7 billion in fresh capital since the start of 2017. That ranks third overall on the top 10 list of inflows year-to-date behind the SPDR S&P 500 ETF (SPY) and iShares Core MSCI Emerging Markets ETF (IEMG), per data from ETF.com.
LQD is the largest dedicated fixed-income sector ETF with total assets of nearly $31 billion. It holds more than 1,700 securities of primarily large cap companies with above investment grade credit ratings. Top bond allocations within this index fund include well-known names such as JM Morgan Chase (JPM) and AT&T Co (T). The total expense ratio to own LQD is just 0.15% and the fund currently sports a yield of 3.45%.
While the price trend in LQD has been choppy over the last year, it’s certainly held up much better than an equivalent basket of treasuries. A performance chart comparing the returns of this ETF versus the iShares 7-10 Year Treasury ETF (IEF) shows a marked gap in total returns.
Corporate bonds have exhibited less downside since the election and continue to generate far superior yields than Treasuries as well. This type of performance divergence is often what big money looks for in allocating to various sectors of the debt markets.
It’s also worth noting that other corporate bond funds are seeing similar interest as well. The Vanguard Intermediate-Term Corporate Bond Index Fund (VCIT) and Vanguard Short-Term Corporate Bond Index Fund (VCSH) have accumulated $2.27 and $1.66 billion respectively since the start of 2017. As their names imply, these index funds invest in broad baskets of corporate bonds across the intermediate and short end of the fixed-income landscape.
One interesting dynamic to note among these ETFs is the high concentration of financial and bank debt among the top sector allocations. According to a recent list of holdings, 27% of the LQD portfolio is allocated to the banking sector, while 33% of the VCIT basket is directed towards finance-related companies. The stocks in these sectors have been some of the strongest in the market since the U.S. election and are anticipated to show improved growth prospects under the policies of the Trump administration.
Furthermore, the liquidity, low cost, and transparency of the exchange-traded fund wrapper make for an enticing investment vehicle versus other alternatives. Investors that are fed up with the high fees of active management may simply be exchanging their legacy mutual funds for more streamlined and inexpensive ETFs.
This dynamic is one that income investors will want to note throughout the duration of 2017. The steady inflows to investment grade corporate bonds will likely accelerate even further if a sell-off in stocks generates a flight to quality. Additionally, this trend signals that the move towards passive investment vehicles is still quite healthy overall.
Disclosure: At the time this article was written, clients of FMD Capital Management owned shares of VCSH.