Growing Risk In Corporate Bond ETFs

July 23, 2018

Figure 3 – Unless the Sustainable GDP Picks Up, the Federal Reserve Runs the Risk of Overshooting in 2019

Perfect Storm Figure 3

(For a larger view, click on the image above)

 

If sustainable growth falters with the Fed’s projected rate path, the Fed runs the risk of overshooting by raising rates higher than what the U.S. economy can shoulder.
 
Asymmetric Risk For Fixed-Income Investors

The window for low cost borrowing on easy credit terms may be closing as the Fed remains committed to its rate hike schedule. Borrowing costs are likely to rise.   

The issue then becomes which speculative-grade borrowers can weather the higher costs assuming a benign macroenvironment.    
 
Even with the recent rise in BBB-rated credit spreads through the end of the seconnd quarter (Figure 4), the risks of owning corporate credit are becoming more asymmetric, especially in light of a flattening yield curve (10- vs. 2-Year U.S. Treasury yields).  

 

Figure 4 – Despite Widening During 2Q, Credit Spreads Remain Narrow Relative to Recent History

Perfect Storm Figure 4
ETF Investors Beware

(For a larger view, click on the image above)

 

The growing composition of BBB/Baa-rated issues held in many common corporate bond ETFs, such as the iShares IBoxx $ Invest Grade Corporate Bd Fund (LQD), is also contributing to this asymmetric risk profile. 

"Baa" bonds today represent about 45% of LQD, up from 36% in June 2015 (Figure 5), and that corporate credit asset class has grown riskier. Up until recently, the compensation demanded by lenders (i.e., credit spread) had shrunk to historically low levels before rising in the second quarter.

 

Figure 5 – Increasing Share of Baa Credit Risk in LQD

Perfect Storm Figure 5

(For a larger view, click on the image above)

 

Investors in fixed-rate preferred equity ETFs face even greater asymmetric risks because many preferred equity issues are now trading at negative yield-to-call or yield-to-worst levels. 

Using the iShares US Preferred Stock ETF (PFF) as a proxy, nearly 25% of the fund is invested in preferred issues trading at negative yield-to-worst levels, according to Bloomberg data. Fixed-preferred investors face heightened credit risk and prepayment risk. 

The macroeconomic and earnings backdrop may still look favorable for U.S. corporations, but a combination of Fed tightening, increasing risk of overshooting, and high corporate debt levels are leaving little room for error should the backdrop turns less favorable.
 
Investors in lower investment-grade credit risk should reassess whether the risks look more balanced in equities than in corporate credit.

Disclosure
At the time of this writing, 3D Asset Management did not hold positions in LQD and PFF. The above is the opinion of the author and should not be relied upon as investment advice or a forecast of the future. It is not a recommendation, offer or solicitation to buy or sell any securities or implement any investment strategy. It is for informational purposes only. The above statistics, data, anecdotes and opinions of others are assumed to be true and accurate however 3D Asset Management does not warrant the accuracy of any of these. There is also no assurance that any of the above are all inclusive or complete.

Past performance is no guarantee of future results. None of the services offered by 3D Asset Management is insured by the FDIC and the reader is reminded that all investments contain risk. The opinions offered above are as July 18, 2018 and are subject to change as influencing factors change.

More detail regarding 3D Asset Management, its products, services, personnel, fees and investment methodologies are available in the firm’s Form ADV Part 2 which is available upon request by calling (860) 291-1998, option 2 or emailing [email protected] or visiting 3D’s website at www.3dadvisor.com.

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