Historical data suggests that the credit markets could do just fine in a rising rate environment. However, corporate bond exchange traded funds may not do so well this time around due to concerns over the substantial run-up in corporate debt.
The iShares iBoxx $ Investment Grade Corporate Bond ETF (NYSEArca: LQD), which tracks investment-grade quality corporate debt, has increased 5.8% year-to-date, while the iShares iBoxx $ High Yield Corporate Bond ETF (NYSEArca: HYG) and the SPDR Barclays High Yield Bond ETF (NYSEArca: JNK), the two largest junk bond ETFs by assets, have gained 3.9% and 4.2%, respectively. [Tempering Rate Risk With Corporate Bond ETFs]
In each of the five times the Fed shifted rates since 1980 and raised its benchmark, investors piled into corporate bonds instead of government debt, betting on greater economic growth, reports Sridhar Natarajan for Bloomberg.
However, with six years of short-term rates near zero and a significant rally in high-yield debt, investors may be ready to exit corporate debt, which would negate any benefits of further growth optimism, according to Citigroup analysts.
“Nobody knows what’s going to happen because we’ve never been here before,” Stephen Antczak, a strategist at Citigroup, the world’s fourth-biggest underwriter of corporate debt, said in the article. “You have untraditional forces at play in the marketplace. This could prevent or diminish the likelihood of the normal pattern of spread tightening.”
Julian Robertson, founder of Tiger Management LLC,argues that there is a bubble in the bonds market after an 83% rally in corporate debt outstanding since 2008.
Additionally, Citigroup analysts have found that corporate treasurers have raised allocations toward company bonds to 16% this year from 14% in 2013, potentially increasing volatility once a sell-off does occur.
“What if this money goes back in cash or Treasuries as yields rise?” the analysts questioned.
Fueling Citigroup analysts’ concerns, the U.S. bond fund market already experienced a $61.7 billion in net redemptions through one period last June in response to the Fed signaling a tapering plan. Once the Fed begins hiking rates next year, some are concerned that the renewed tightening rhetoric would instigate another broad sell-off, as opposed to putting the focus on reasons for raising rates in the first place, such as controlling a quickly expanding economy.
iShares iBoxx $ Investment Grade Corporate Bond ETF
For more information on corporate debt, visit our corporate bonds category.
Max Chen contributed to this article.
Full disclosure: Tom Lydon’s clients own shares of LQD, HYG and JNK.