The case of the iShares iBoxx $ Investment Grade Corporate Bond ETF (NYSEARCA:LQD) is quite simple. It is an ETF invested in longer-term bonds, mainly at fixed rates, in an environment where rates are rising. Bonds really have a duration that goes against them all the more so unemployment drops shockingly. Not the right stock to have right now if the Fed really wants to fight inflation.
The notion of duration is central in finance. The duration is the effective maturity of the bond, which means that it is weighted to something less than the period of the bond’s final payment because part of the value of the bond, often coming from coupons , occurs earlier in the life of a bond. If a bond has a longer effective maturity at a fixed interest rate, that means investors are committing longer at an interest rate that was once the market rate, and if rates are rising as they are now , you will be hired longer at an uneconomical rate. It’s just that longer duration bonds lose value more markedly as rates rise.
Distribution of LQD
There’s nothing too much of a concern with LQD’s credit quality, at least on the face of it. The problem lies in the duration of the bonds. The life of bonds is usually quite long, with the average maturity being between 7 and 10 years, and the effective maturity probably being a little lower than that due to the coupons.
The problem is that while it previously looked like rate hikes might slow after the second 75 basis point hike, unemployment actually continues to be low, in fact it has fallen despite the rate hikes. We are now back to a Phillips curve world where if unemployment is low, inflation should be higher. Yes, consumer spending has plunged, but if unemployment is that low, that could reverse soon unless the Fed, still determined to bring inflation down, continues its anti-inflation crusade. They may or may not, but they said they will and they have to raise rates to do it, apparently given the unemployment data. More and more banks are now following in the Fed’s footsteps, with the BOE raising rates and giving bleak recession forecasts. LQD is down 12% since the start of the year, but with relatively high duration bonds, mainly fixed rates, things could get even worse.
The yield is even quite attractive at 4.4% and the fees are less than 0.2%, but at the end of the day, value is value. The high duration bonds carried by LQD are simply not suitable for the current environment, and this 4.2% net yield is not good for an A credit rating when the risk-free rate is 3% or more. . This is a risk premium that could even be less than 1%. Rather uninteresting risk remuneration. We prefer to have the flexibility in the face of inflation or higher rates than other equity-based investments have to offer.
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