Corporate Debt Sales Raise ETF Questions

April 09, 2014

The biggest wave of corporate issuance in years begs the question, Is it good for you?

U.S. companies issued $317 billion in debt in the first quarter—the most in five years—and ETF investors will soon have access to a lot of these bonds through various corporate-bond ETFs. But given the specter of rising rates, investors should think carefully about the way such “spread” products work in a rising-rate environment.

“There’s a risk combination of rising rates and the possibility of widening credit spreads,” J.R. Rieger, vice president of fixed-income indices for S&P Dow Jones, told “It could be a double whammy for investors. They need to be fully aware of the risks in this segment.”

To be sure, there’s no reason to think the corporate bond market is unusually vulnerable right now. So far this year, U.S. bond ETFs have attracted $10.75 billion in fresh new assets despite the ongoing concern about rising rates. Those inflows far outpaced the wave of money going into equities ETFs—an indication that, on balance, the fear of rising rates isn’t as widespread as some headlines suggest.

There are plenty of advisors like Hahn Investments’ Tyler Mordy in Toronto who see the normalization of rates as a long process and, moreover, stress that no matter what is happening in the bond markets, there’s a demographic wave of retirees that’s so big that demand for fixed income is a given for years.

Viewed from an ETF perspective, funds like the iShares 1-3 Year Credit Bond ETF (CSJ | A-89) ranked as some of the most popular ETFs in the market in the first quarter, raking in $1.42 billion in net inflows in the three-month period. Also, the huge iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD | A-66) attracted a fresh $588 million in the quarter, pushing it above $16.5 billion in total assets.

Judgments about demand notwithstanding, the paltry compensation might. Traditionally, the big attraction of investment-grade corporate debt is that it compensates investors for taking on credit risk.

Reaching For Yield?

But to get better yields, investors would be taking additional interest-rate risk, and at current levels, it’s not clear corporate bond yields are attractive enough to compensate you for that risk, S&P Dow Jones’ Rieger said.

With the Federal Reserve tapering five years of quantitative easing, Treasury yields are going to tick higher, which means corporate yields will move higher more quickly, as they typically do, he says.

According to S&P Dow Jones data, in a broad market sense, the investment-grade corporate bond market is exposing investors to more duration risk than comparable Treasurys—and only for a small incremental difference in yields.

For example, the average yield-to-worst in the S&P Investment Grade Corporate Bond Index is currently 2.97 percent, while 10-year Treasurys are yielding 2.75 percent, according to S&P Dow Jones data. That’s seems OK, but for one troubling aspect: The high-grade corporates universe has duration of about 6.5 years in the aggregate right now, compared with 3.8 years in the broad Treasurys markets, Rieger says.

“Corporates offer more duration risk from a broad market perspective than Treasurys right now,” he noted. “The question is, Are investors being compensated enough for that duration risk?”


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