By Timothy Strauts
Corporate bonds have had a very consistent performance record.
iShares iBoxx $ Investment Grade Corporate Bond (
) returned 12.1%, 9.1%, 8.9%, and 11.7% per year from 2009 to 2012.
Is this level of performance realistic going forward? We think the
answer is no. That doesn't mean you should avoid corporate bonds,
but you should have realistic expectations about future
Corporate Bond Basics
High-quality corporate bonds offer relatively safe income and
typically yield more than United States Treasury bonds because of
their credit risk. Long-term investors could own LQD as part of a
diversified-bond allocation, and tactical investors could own this
exchange-traded fund when they feel the corporate-bond market is
underpriced versus Treasuries. This fund holds investment-grade
paper with an average rating of BBB. Still, that does not make the
fund immune to losses, even if the actual creditworthiness of its
underlying companies remains unchanged. Corporate spreads can
widen, inflicting losses on funds like this one, because of factors
such as liquidity and changing opportunities in other areas of the
Investors should also be aware that a corporate-bond ETF such as
LQD often has substantial overweightings to certain sectors
relative to the S&P 500. For example, LQD has a 33% weighting
in financials compared with the 15% weighting in the S&P 500.
Also, like all bond funds in general, this ETF is subject to
inflation and interest-rate risk. The market currently expects
inflation of 2.1% over the next five years. If inflation
expectations or interest rates rise, the value of the underlying
bonds will decline.
LQD has had very strong inflows over the last two years as
investors have flocked to fixed income. With over $25 billion in
assets, it's by far the largest corporate-bond ETF. The
second-largest fund only has $5 billion. LQD has an average trading
volume of 2 million shares per day, giving it substantial
liquidity; in many ways it has become the de facto proxy for the
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Tremendous demand for corporate bonds and actions by the Federal
Reserve have lowered yields to historical lows. The BofA Merrill
Lynch US Corporate BBB Index had a yield of 9.8% in January 2009.
Today the index has a yield of 3.3%, which is near historical lows.
Steadily falling rates would explain the above-average returns that
investors have received over the past four years.
On a credit-spread basis, corporate debt looks a little more
attractive. The BofA Merrill Lynch US Corporate BBB Spread Index,
which calculates the difference in yield between an AAA U.S.
Treasury bond and a BBB rated corporate bond, shows a spread of
1.94% as of Jan. 9. The average spread since 1997 is 2.13%. While
spreads are below average, they're not extremely overvalued.
LQD has an average credit quality of BBB and SEC yield of 2.78%.
The Fed has pledged to keep interest rates low for the foreseeable
future, so investors should expect returns between 2% and 4% over
the next few years. It is unlikely that rates will drop much more,
so investors won't be able to rely on capital gains going
The biggest risk to an investor is the potential for rising
interest rates. With an average duration of 7.8 years, LQD is
heavily exposed to this risk. If rates rise just 1%, LQD would have
about an 8% loss.
LQD tracks the corporate-bond market as defined by the Markit iBoxx
USD Liquid Investment Grade Index. The index tracks a basket of
representative investment-grade corporate-bond issues that have a
maturity of between three and 25 years. The fund holds more than
1,000 bonds and has an average duration between seven and eight
years. The average credit rating of the fund is BBB. As of January
2013, the sector breakdown for the fund was 34% financials, 12%
consumer staples, 11% oil and gas, 8% telecom, 8% consumer goods,
and 8% health care.
LQD charges a 0.15% management fee, which is on par with other
corporate-bond ETF offerings.
There are three direct competitors to LQD in the intermediate-term
corporate-bond space. They are iShares Barclays Credit Bond (
), Vanguard Intermediate-Term Corporate Bond Index ETF (
), and PIMCO Investment Grade Corporate Bond Index ETF (
), which carry expense ratios of 0.20%, 0.12%, and 0.20%,
respectively. All alternatives have a slightly shorter duration
than LQD. High trading volumes and a large asset base give LQD
stronger liquidity, which makes it the preferred fund in this
Investors looking for shorter-duration credit bond exposure
might want to look at iShares Barclays 1-3 Year Credit Bond (
). This fund has a duration of only about 2.0 years, and its
holdings include investment-grade sovereign debt as well as
: Morningstar, Inc. licenses its indexes to institutions for a
variety of reasons, including the creation of investment products
and the benchmarking of existing products. When licensing indexes
for the creation or benchmarking of investment products,
Morningstar receives fees that are mainly based on fund assets
under management. As of Sept. 30, 2012, AlphaPro Management,
BlackRock Asset Management, First Asset, First Trust, Invesco,
Merrill Lynch, Northern Trust, Nuveen, and Van Eck license one or
more Morningstar indexes for this purpose. These investment
products are not sponsored, issued, marketed, or sold by
Morningstar. Morningstar does not make any representation regarding
the advisability of investing in any investment product based on or
benchmarked against a Morningstar index.
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