What Are Investment Grade Corporate Bonds?
Investment-grade rated corporate bonds are issued by corporations with a credit rating of BBB- or higher from Standard & Poor’s or Baa3 or higher from Moody’s (lower than that is the high-yield or “junk bond” category). Investment grade bonds are often issued by blue chip companies with well-known brands and solid fundamentals and a reasonable expectation and ability to repay their debt obligations. They have yields higher than U.S. Treasuries but lower than High-Yield Corporate Bonds. They have historic default rates of about
What’s the Concern for Investment Grade Bonds?
Many individual investors have also become complacent when it comes to buying corporate bonds, even one’s with the highest (investment grade) ratings. The introduction of ETFs has allowed investors easy access to sector they might not have participated in prior. The pooling of these bonds into a securitized product entices investors to take reach who feel the corporate bond risks have been diversified away.
Corporations issued debt at worrisome levels, taking advantage of record low interest rates. There’s a struggle between equity shareholders and debt holders interests. This debt has been (arguably) benefitting the equity shareholders at the expense of creditors since much of the proceeds from these bond offerings are being used to either issue and pay dividends or to repurchase stock. This decreases the ability of the company to repaying debt, putting creditors at risk. For some companies that issue debt frequently, each subsequent debt offering harms the creditors from prior offerings.
One of the most popular ETF has been the iShares IBOXX $ Investment Grade Corporate Bond ETF (LQD) which currently yields about 3 1/2% (Sept, 2015). This level of yield understates risk. Many investors think investment grade corporates have pristine credit ratings. But only about 1% of this fund (and thus, the index since it passively follows that) is AAA rated by S&P. The portfolio consists of 41% BBB (the lowest investment grade rating level before junk which is BB) and another almost 47% just single A. The majority of the fund/index straddles the border with high yield so this really isn’t as safe as many believe. If interest rates rise substantially, investment grade bonds will get hit hard.
Lastly, the ability of investors to get out of a fund like LQD could become complicated if the underlying bonds have trouble trading. Market makers could simply step away from LQD (like they did for other ETFs in August of 2015) if they can’t determine the values of the underlying holdings or the fund could freeze. Dealer inventories at broker-dealers have also been slashed due to post-financial crisis regulations so the willingness of market makers to handle sell large sell orders is questionable, which could result in outsized price movements.
How to Hedge Investment Grade Corporate Bonds
Using an inverse corporate bond ETF might be a viable way to hedge some exposure to that section of a bond portfolio if you don’t want to liquidate your holdings for a variety of reasons (taxes, income needs, illiquidity, etc).
There are a few inverse bond ETFs to hedge some risk to your investment grade bond positions. ProShares offers the Short Investment Grade Corporate Bond inverse ETF, IGS. This fund aims to return the opposite (-1X) of the Markit iBoxx USD Liquid Investment Grade Index on a daily basis. It can be thought of as the inverse of the LQD since they track the same benchmark. But while the LQD has significant assets under management, IGS is small with a few million in assets and around one thousand shares traded daily. There are also a small number of counterparties.
ProShares has a more popular Investment Grade Interest Rate Hedged ETF, IGHG which holds investment grade bonds but hedges that portfolio by shorting U.S. Treasury bonds to reduce duration risk (ideally to zero duration). These investment grade bonds are sensitive to rate increases with an effective duration in the portfolio of over 8 years (Sept. 30, 2015). Many issuers have extended out maturities so interest rate risk is a concern. The Treasury hedge should help, but it won’t hedge out credit risk. It also has a reasonable expense ratio of about 30 basis points.
Finally, investment grade corporates are the largest weighting in investment portfolios of many large insurance companies so hedging with an inverse financial ETF with a large weighting of insurers is a viable option. FINZ is a single inverse financial ETF. Buying put options on XLF, which often has one or two large insurers in their top ten holdings list, is another idea. LQD has roughly 31% of its portfolio weighted in financials (banking, finance companies and REITs).