Beware Possible Rip Current Under ‘LQD’

The great rally and asset inflows into investment-grade corporate ‘LQD’ might be about to come face to face with a mean reversion.

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Reviewed by: Cinthia Murphy
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Edited by: Cinthia Murphy

The iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD) was the most popular fixed-income ETF in August, raking in $1.3 billion in fresh net assets last month. The ongoing massive inflows into this ETF are beginning to worry some market experts.

Consider that the August inflows brought LQD’s net asset gains for 2016 to an impressive $6.8 billion—the fourth-largest year-to-date net creations among all ETFs and a 20% jump in the fund’s AUM. LQD today has $33 billion in total assets.

The fund’s popularity with investors this year, many say, is yet another indication of investors’ desperate search for income. In a world of compressed yields around the globe, and low-returning stocks, corporate credits are a good place to be if you are looking for yield.

LQD is currently shelling out 30-day yields of 2.85%, and a distribution yield—the 12-month yield an investor would get if the latest distribution and share price stayed the same—of 3.05%. That’s for a portfolio that has effective duration of about 8.5 years. (Effective duration is a measure of the fund’s sensitivity to interest rate changes.)

For perspective, 10-year Treasurys are yielding about 1.67%. A Treasury fund such as the iShares 7-10 Year Treasury Bond ETF (IEF), which has effective duration of about eight years, is serving up 30-day yields of 1.35%—less than half that of LQD.

And performance has been good too. The chart below shows LQD’s year-to-date gains relative to IEF, as well as the SPDR S&P 500 (SPY), and an aggregate bond strategy, the iShares Core U.S. Aggregate Bond ETF (AGG). LQD is the best-performing of the bunch, and by a good margin: 

 

Chart courtesy of StockCharts.com

 

But there are signs of trouble lurking, Bob Smith, president and chief investment officer of Sage Advisory Services in Austin, Texas, said.

“LQD is not bad in and of itself, but it’s like the SPDR Gold Trust (GLD) to the average small investors,” he said. “They race in when gold is hot, and they race out when it’s not. The problem is that the bigger it becomes, the more difficult it is to sustain balance in that market when the flows go the other way, if they do.”

 

Specifically of concern is the liquidity of the underlying market. LQD cannot “outstrip” the inherent underlying liquidity of the cash market, but the cash market trades a “splinter” on a day-to-day basis to what LQD does in terms of volume, according to Smith, whose firm manages some $12 billion in assets and is known for its expertise on fixed income.

If markets can’t be made in the event of a massive exodus, investors will have to “take it on the chin” for a while because prices will adjust, and quickly, Smith says.

The Federal Reserve could also play a role in what happens next to a fund such as LQD, and the $8 trillion corporate bond market.

As Brett Owens, a contributor for Forbes, pointed out this week in an article: “If Yellen and the Fed raise rates, LQD’s bonds will decline in value—and so will the ETF’s stock price. That’s what we saw last year, when the fund fell nearly 5% as the Fed chattered about rates and finally raised them in December.”

Getting Down To Fundamentals

There’s also the issue of fundamentals. Credit quality is getting pressed, and fundamentals are getting “shabbier and shabbier.” There’s a growing number of companies that are being added to the watch lists of ratings agencies such as Standard & Poor’s and Moody’s, Smith notes.

“The number of companies that are now on the negative watch list is at levels that are higher than prior to 2008,” he said. “We’ve had five quarters of shabby earnings, and these companies have been leveraging themselves out with stock buybacks and dividend payouts. That’s unsustainable.”

“At some point, the spring will pop,” Smith added. “I don’t know what the event will be to trigger this, but spreads are getting tight, there’s a distension in the marketplace, and underlying fundamentals are getting weaker, not stronger. There has to be a mean-reversion.”

His advice? It’s hard to give up the carry, yes, but you shouldn’t be overloading on this position at this point.

“Be careful,” Smith said. “Make sure you’re getting the reward for the risk you’re taking because things are getting stretched, and don’t think Mr. Liquidity is going to be welcoming you at the door of ‘Transactionville’ saying ‘let’s get your trade done right away.’”

Contact Cinthia Murphy at [email protected]

 

Cinthia Murphy is head of digital experience, advocating for the user in all that etf.com does. She previously served as managing editor and writer for etf.com, specializing in ETF content and multimedia. Cinthia’s experience includes time at Dow Jones and former BridgeNews, covering commodity futures markets in Chicago and Brazil equities in Sao Paulo. She has a bachelor’s degree in journalism from the University of Missouri-Columbia.