Don’t Expect Corporate Bond ETFs to Rally Forever
January 22nd, 2013 at 6:08am by Tom Lydon
Corporate bonds and related exchange traded funds have generated solid returns over the past few years as investors shifted away from low-yielding Treasuries and into riskier assets. However, potential investors should not get their hopes up as future returns may be tempered.
“Is this level of performance realistic going forward? We think the answer is no,” Timothy Strauts, Morningstar ETF analyst, said. “That doesn’t mean you should avoid corporate bonds, but you should have realistic expectations about future returns.”
Back in 2009, the BofA Merrill Lynch US Corporate BBB Index had a yield of 9.8%, but the index yield has dropped to 3.3%, near historical lows. Yields and bond prices have an inverse relationship – as yields dropped over the past few years, bond prices have been rising. LQD has a 2.78% 30-day SEC yield. [Investors Pile Into Corporate Bond ETFs as Credit Quality Declines]
Investment-grade corporate debt provides attractive yields compared to U.S. Treasuries because of their credit risk, but they remain relatively safe. Long-term investors utilize corporate bond investments, like LQD, as part of a diversified fixed-income portfolio. On the other hand, tactical traders would consider the asset when they believe the corporate bond market is underpriced compared to Treasuries.
Potential investors should also be aware that corporate-bond ETFs, like LQD, may favor a particular area. For instance, LQD has 33% of its portfolio in financials.
Looking ahead, corporate bond ETFs, like other bond funds, are subject to inflation and interest-rate risk – the underlying bond will depreciate in value as inflation expectations and interest rates rise. Strauts notes that with a 7.8 year average duration, LQD could experience an 8% loss if interest rates rise 1%.
Nevertheless, glancing at the spreads, corporate debt is not overvalued. The BofA Merrill Lynch US Corporate BBB Spread Index, which calculates the difference in yield between AAA U.S. Treasuries and a BBB rated corporate bond, has a 1.94% spread, compared to the average 2.13% since 1997.
Alternatively, other similar ETF products include:
- iShares Barclays Credit Bond (NYSEArca: CFT): 2.37% 30-day SEC yield.
- Vanguard Intermediate-Term Corporate Bond Index ETF (NYSEArca: VCIT): 2.57% 30-day SEC yield.
- PIMCO Investment Grade Corporate Bond Index ETF (NYSEArca: CORP): 2.62% 30-day SEC yield.
For more information on corporate debt, visit our corporate bonds category.
Max Chen contributed to this article.
Full disclosure: Tom Lydon’s clients own LQD.
The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.