High-Grade Corporate Bonds
Investment-grade corporate bonds are very cheap at today's prices. According to a recent Morgan Stanley report, current corporate bond prices imply a cumulative 36% default rate in the next five years. This is staggering—more than 7.5 times greater than any previous, actually experienced, five-year default rate. David Swensen, Yale Endowment Fund's chief investment officer, predicts investment-grade corporate bonds will provide patient investors with "equity-like" returns over the next 3 to 5 years.
Additionally, many bond experts agree with Tim Bond's (Barclays Capital's head of Global Asset Allocation) remark to the Financial Times, "Investment-grade Corporate Bond 'spreads' (the difference between Treasury Bond and Corporate Bond yields) are at levels last seen in 1932, which happened to be an excellent point to buy credit—even though it was the middle of the Great Depression."
Yields on investment-grade corporate bonds have been pushed to 5-6% above comparable maturity Treasuries. Portfolio managers are currently snapping up corporate bonds issued by money-center banks, brokers and the largest insurers, as the ongoing government bailout may mitigate some of the risks of corporate defaults.
The only 100% investment-grade corporate bond ETF is iShares iBoxx $ Investment-Grade Corporate Bond Fund (NYSE: LQD). LQD is distributing a robust 5.6%, but this higher yield comes at the cost of high volatility as well. In the three weeks following the September 15, 2008 Lehman Brothers bankruptcy, LQD plunged 25.4%, nearly matching the 32% S&P 500 decline. By January 9, 2009, LQD shot up 35% from its October 10, 2008 low. Recently, LQD has fallen back about 5% from its peak value earlier in January, marking a reasonable entry point for new purchases.
LQD seeks investment results corresponding to the price and yield performance of the iBoxx $ Liquid Investment-Grade Index. This index measures the performance of 100 highly liquid, investment-grade, U.S. dollar-denominated corporate bonds. The average duration of its bonds is 6.25 years, daily trading volume exceeds 800,000 shares and its market cap is $3.7 billion. Despite the low yields and warnings of Pimco and others, if you're willing to blend some Treasuries into your bond portfolio, also look into:
- iShares Barclays Aggregate Bond Index (NYSE: AGG)
- Vanguard Total Bond Market ETF (NYSE: BND)
- SPDR Barclays Aggregate Bond ETF (NYSE: LAG)
Each of these three ETFs attempts to replicate the Barclays Capital U.S. Aggregate Bond Index, which is diversified into three asset classes:
- Treasury and Agency bonds (approximately 37%)
- Mortgage-Backed Securities (38%)
- Investment-Grade Corporate Bonds (25%)
Maturities in this index are relatively short, with 39% of the portfolio maturing in one year or less, and another 34% maturing in less than five years. The average maturity is currently 6.8 years.
The State Street Global Advisor's SPDR Barclays Aggregate Bond ETF (LAG), has a modest $10 million market cap and trades 31,000 shares daily. While Vanguard's Total Bond Market (BND) is a viable contender, AGG is top dog with its $9.7 billion market cap and daily 800,000 shares average trading volume.
2008 performance and yield of the Barclays Aggregate Bond Index and its three index tracking ETFs were excellent. From the Lehman Brothers collapse on September 15, 2008, to the market trough on October 10, 2008, AGG dropped 14.9%, BND lost 14.2% and LAG was down 16.6%. The ensuing recovery into early January was quite dramatic. AGG and BND recovered 21% and 18%, respectively, and LAG bounced back 26%. Through February 6, 2009, AGG, BND and LAG have dropped a modest 3.6%. Current distribution yields are 4.6% for AGG, 4.5% for BND and 3.8% for LAG.
In my next column, we'll consider two additional income-producing asset classes: senior loans and preferred stocks. But for now, your best bets for principal safety and steady income seem to be mortgage-backed securities, Treasury inflation protected securities (TIPS), municipal bonds and high-grade corporate bonds. Sleep well.
Chance Carson is president of Alpine Strategies in Colorado Springs, Colo. He also serves as editor of AboutETFs.com, an educational Web site for retired investors. He welcomes comments and suggestions for future columns at [email protected].