Tag Archives: lqd

LQD: This Huge Bond Fund Looks Very Solid

Summary LQD offers investors exposure primarily to the 3 to 10 year portion of the bond market with 27% going to the very long portion of the yield curve. Allocations to the very long end of the yield curve (over 20 years) combine with investment grade credit quality to create negative correlation with the S&P 500. The expense ratio is a little higher than I like to see, but it isn’t too bad. Compared to a large bid-ask spread on other bond ETFs, total ownership cost should be attractive. It appears the fund has free trading through TD Ameritrade and Fidelity. The iShares iBoxx $ Investment Grade Corporate Bond ETF (NYSEARCA: LQD ) is a huge bond ETF. The ETF has around $24 billion in assets under management. While the additional size may not be a substantial factor for shareholders, the average trading volume over 900,000 shares translates into around $10 million per day. For investors that want to be able to move in and out of the bond market, high liquidity is a huge advantage since it reduces the bid-ask spread. Expenses The expense ratio for LQD is.15%. This isn’t the best expense ratio an investor can find, but isn’t too high either. The real question here is how long an investor would plan to hold the fund. If the holding period is several years then there is an advantage to going for a rock bottom expense ratio. Some of the smaller bond ETFs have demonstrated bid-ask spreads greater than 1%. That can be a real pain. Crossing that bid-ask spread once would be equivalent to the expense ratio for 7 years. Add in that investors are only going to save a few basis points and there are some material advantages from the better liquidity of LQD. Yield The yield is 3.46%. It isn’t very high, but as you’ll see when we go through the portfolio this is investment grade corporate debt with only moderate duration exposure. Duration The following chart demonstrates the sector exposure for this bond fund: This is a fairly nice collection. The fund is pretty much excluding short duration bonds that have fairly weak interest rates in favor of holding those along the middle of the yield curve. To boost yields there is also a material allocation to the very long duration securities. Sectors The following chart demonstrates the sector exposure for this bond fund: I don’t see a huge problem here. The fund avoids having a huge exposure to the energy sector which is beneficial since the falling prices could trigger downgrades for several of the smaller companies in the sector. Since the fund is holding investment grade debt and has an enormous amount of assets, having to sell off bonds from a smaller issuer after a downgrade could push the price of those bonds down due to illiquidity of the underlying bonds. The allocation list goes on to include several incredibly tiny sector allocations. If you wish to see the full list, it is available on the fund’s website . Credit The next major issue to look at is the credit rating of the companies in the fund. The debt is investment grade, but the fund is walking the line in that regard to generate higher yields. As long as the management is watching the underlying liquidity, I don’t see a problem. Notice that there is a very little investment in AAA rated debt. This fund intends to take on some credit risk to enhance returns, but it doesn’t intend to take on much. For the investor seeking stronger yields than treasuries can provide without the credit risk of junk bond funds, this is a fairly reasonable compromise. By focusing on investment grade debt and incorporating some longer maturities the fund retains a negative correlation with the S&P 500. Over the last 2 years that correlation was -.15. For the investor that likes to rebalance their holdings occasionally and values negative correlation for the market the liquidity here really shines. Conclusion Overall this is a fairly solid bond fund. The duration risk is not overwhelming, but it is enough to generate negative correlation to the broader stock market. For any shorter term bond investments, the liquidity here trumps the difference in expense ratios. I did a quick search on brokerages with free trading on the ETF since an investor planning to rebalance or adjust their position frequently would want to avoid commissions. It appears TD Ameritrade and Fidelity are offering commission free trading on LQD. I’m giving this bond fund a 9.5/10 rating. If the expense ratio dipped under .10%, it would be a very solid 10.

Lipper U.S. Fund Flows: Gains For All 4 Fund Groups

By Patrick Keon Lipper’s fund macro-groups (including both mutual funds and exchange-traded funds [ETFs]) had aggregate net inflows of $14.0 billion for the fund-flows week ended Wednesday, October 14. This activity marked the second consecutive week of overall positive flows; the groups took in $11.8 billion of net new money the prior week. The wealth was spread out this past week, with all four fund macro-groups experiencing positive net flows: money market funds (+$7.9 billion) led the pack, followed by taxable bond funds (+$3.1 billion) and equity funds (+$2.5 billion), while municipal bond funds contributed $521 million. The downturn at the end of the week was triggered by weak economic data from both domestic and foreign sources. Reports out of China again raised global growth concerns. China’s economic growth for Q3 2015 was forecasted to be 6.8%, the lowest level since 2009, giving investors concerns as to whether the slump in the world’s second largest economy is worse than originally thought. On the home front, corporate earnings and a gloomy picture of U.S. growth weighed on the markets. Wal-Mart (NYSE: WMT ) issued a much weaker-than-expected profit forecast, which-coupled with the release of a weak U.S. retail sales report-resulted in a sell-off in the retail sector. The Federal Reserve’s Beige Book pointed toward a continued slowdown in U.S. growth. With economic data continuing to point to weakness and the inflation rate sitting well below the target rate of 2.0%, it seems the likelihood of the Fed raising interest rates in 2015 is getting slim. The week’s positive flows into money market funds (+$7.9 billion) marks the fourth consecutive week of net inflows for the group over which time they have taken in almost $42 billion. Institutional money market funds were responsible for the lion’s share of the positive flows last week, taking in $8.2 billion in net new money this past week. ETFs (+4.7 billion) were responsible for all of the equity net inflows for the week, while equity mutual funds saw $2.2 billion leave their coffers. The Powershares QQQ Trust ETF ( QQQ , +$1.3 billion ) and the iShares Russell 2000 ETF ( IWM , +$911 million ) had the two largest net inflows on the ETF side, while for mutual funds both domestic (-$1.6 billion) and nondomestic (-$700 million) equity funds experienced net outflows. ETFs (+$2.6 billion) contributed the majority of the net new money for taxable bond funds, while taxable bond mutual funds chipped in almost $500 million. The iShares iBoxx $ High Yield Corporate Bond ETF ( HYG , +$616 million ) and the iShares iBoxx $ Investment Grade Corporate Bond ETF ( LQD , +$608 million ) were the two largest contributors to the positive flows for ETFs. Lipper’s High Yield Funds (+$378 million) and U.S. Mortgage Funds (+$326 million) classifications had the two largest increases for mutual funds. Municipal bond mutual funds took in $482 million of new money for their second straight week of net inflows. The majority of these inflows (+$319 million) came from funds in Lipper’s national municipal bond fund groups.

What Will Get Hit Worst When Rates Rise

Summary John Authers argues the assets that will be worst affected by the Fed raising rates are ones paradoxically considered lower risk. These assets are high quality corporate bonds and municipal bonds, particularly those of longer duration. We highlight two bond ETFs that may fit those criteria and offer ways for investors to limit their risk. The Paradox Of Risk In his Long View column in Saturday’s Financial Times (“Dress rehearsals set stage for how assets will react to rate rise”), John Authers pointed out a paradox of risk: Generally, risks are greatest when there are not perceived. People who have bought a security believing it to be high-risk tend to guard themselves against the risk; those who think they have a low-risk investment do not. This could therefore amplify the chance of a full-blown financial “accident.” The putatively low-risk assets Authers has in mind are bonds, specifically higher-quality corporate and municipal bonds of longer duration, and the threat he sees is of the Fed raising rates. How Rising Rates will Hit High Quality Corporates and Munis Although Authers thinks a rate rise this week is unlikely, he sketches out the potential consequences of an eventual series of rate hikes: Higher target rates set by the Fed will send bond yields higher, which means bond prices must go down. With yields already low, the proportionate falls in prices need to be that much greater. Why would high-quality corporate bonds and munis fare worse than other types of bonds? Authers believes that Treasuries will benefit from a flight-to-quality in the event of a rate rise, and junk bonds will be less sensitive to interest rates because they carry greater credit risk. That leaves higher quality corporate bonds and municipal bonds. Authers notes a difference in market structure for bonds that makes the credit market “lumpier” than the stock market: rather than trading on an exchange, most bonds are sold through dealers; and since banks have, since the financial crisis, cut back on the capital they allow their dealers to spend on bonds, there may be fewer institutional buyers to support flagging bond prices. Duration and Interest Rates Bonds vary in their sensitivity to interest rate movements according to factors including their time to maturity. The finance term used to express interest rate sensitivity is duration, and it is expressed as a number of years. The longer a bond’s (or bond ETF’s) duration, the more sensitive it will be to interest rate movements. Two Bond ETFs that May Be at Risk In his column, Authers warned about longer duration bonds, but didn’t quantify what he meant by longer duration. According to Fidelity though, the average duration for fixed income ETFs is 4.43 years. Two ETFs that invest in high quality corporate bonds and municipal bonds, respectively, and have effective durations higher than that are the iShares National AMT-Free Muni Bond ETF (NYSEARCA: MUB ) and the iShares iBoxx $ Investment Grade Corporate Bond ETF (NYSEARCA: LQD ). Both ETFs invest in higher quality bonds. According to its fact sheet , only 0.04% of MUB’s bonds are non-investment grade (BB-rated). The rest are BBB-rated (1.25%), A-rated (28.89%), AA-rated (48.81%) or AAA-rated (21.82%). Its effective duration is 4.75 years. According to LQD’s fact sheet , the bulk of its bonds are either BBB-rated (39.52%) or A-rated (47.68%). The rest are AA-rated (10.8%) or AAA-rated (1.7%). Its effective duration is 8.04 years. Ways For ETF Investors To Limit Their Risk If you own these ETFs, agree with Authers’ thesis, and expect a rate rise sometime in the next several months, there are a couple of ways you can limit your risk. The simplest way is to sell them. If you’d rather not keep your money in cash after selling them, we looked at a low-risk alternative to cash in a recent article (“An Alternative to Cash for a Risk-Averse Investor). Another way to limit your risk if you own these ETFs is to hedge them. You can hedge them by buying optimal puts on the ETFs to limit your downside risk. Puts (short for put options) are contracts that give you the right to sell a security for a specified price (the strike price) before a specified date (the expiration date). Optimal puts are the ones that will give you the level of protection you are looking for at the lowest cost. This page offers more detail on how optimal puts can limit your downside risk. Below are sample hedges for both of the ETFs we’ve discussed here. Hedging LQD against a > 15% decline by March 17th These were the optimal puts, as of Friday’s close, to hedge 1000 shares of LQD against a greater than 15% drop between now and March 17th. As you can see at the bottom of the screen capture above, the cost of this protection, as a percentage of position value, was 0.56%. Note that, to be conservative, this cost was calculated using the ask price of the put options. In practice, you can often purchase put options for less, at some point between the bid and the ask prices. Hedging MUB against a > 15% decline by February 18th These were the optimal puts, as of Friday’s close, to hedge MUB against a greater-than-15% decline between now and February 18th. The cost of protection for the MUB hedge above is 0.41% of position value (calculated in the same conservative manner as above for LQD). It’s not surprising that the LQD hedge is a little more expensive; all else equal, you’d expect it to be a little more expensive because it expires a month later than the MUB hedge. What’s a bit surprising is that it’s not more expensive relative to MUB, given LQD’s lower average credit quality and its significantly higher effective duration. Perhaps the answer is in the paradox of risk offered by Authers: most LQD investors don’t see it as a risky investment, so they haven’t bid up the cost of hedging it. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.