U.S. Corporate Bond ETFs: Still Viable?

Investment grade corporate bond ETFs are generally predictable and exposed only to interest rate risk. Some investors find them boring. The financial crisis in the Fall of 2008, however, proved that on occasion they can be anything but boring. During the crisis only Treasuries seemed safe. This caused unusually furious selling in market and major setbacks for U.S. corporate bond ETFs. Many of these ETFs have since snapped back, but should investors rethink their U.S. corporate bond allocation?

Though already in slow decline, the trouble for U.S. corporate bond ETF performance began in earnest mid-September of 2008 with the collapse of Lehman Brothers. Perhaps for the first time since Enron scandal, investors began to worry about counterparty risk. As much as 40% of the securities held in the portfolios of investment grade corporate bond ETFs were issued by financial institutions. Lehman's bankruptcy meant the unimaginable: ETFs built of high-grade corporate bonds were at risk. The result was what can only be described as a panic.

The chart below compares the returns of key U.S. fixed income ETFs during this period.

The chart shows the U.S. investment grade corporate bond ETFs: iShares iBoxx Investment Grade Corporate Bond (PCX:LQD) and iShares Credit Bond (NYSEArca:CFT) with 0.15% and 0.20% expense ratios respectively falling sharply as the credit crisis got underway. These ETFs fell around 20% from the middle of September to the middle of October. This may seem good compared to the nearly 30% decline in the S&P 500 Index during that same period. But the rationale for owning bond ETFs and foregoing the higher long-term returns supposedly offered by equity products is protection against this kind of move. Not only did corporate bond ETFs sell, from a portfolio perspective they sold at the worst time. As the chart shows, the only fixed income product to buck this trend were pure treasury bond funds like iShares Barclay's 7-10 Year Treasury (NYSEArca:IEF), with an expense ratio 0.15%.

The chart also shows the returns of a couple other key fixed-income products: iShares iBoxx High Yield Corporate Bond (NYSEArca:HYG) with an expense ratio of 0.5% and iShares Barclay Aggregate Bond (NYSEArca:AGG) with an expense ration of 0.2%. AGG is the largest and most diversified of the funds shown in the chart. During the worst of the crisis it outperformed LQD and CFT largely due to its mix: only about 25% of its portfolio is devoted to high-grade corporates. The remainder of the fund is divided about evenly between high-quality mortgage-backed securities (MBS) and US. Treasury/Agency Bonds. AGG competes directly with Vanguard Total Bond Market (NYSEArca:BND), with an expense ratio of 0.11% and the SPDR Lehman Aggregate Bond (NYSEArca:LAG), with an expense ratio 0.13%. We like both AGG and BND. The expense ratio of AGG is slightly higher, but it is an effective and at close to 10 billion in assets, liquid and highly established. During the worst moments of the crisis this helped AGG to trade closer to NAV than BND. BND has assets of around 3 billion. LAG, the smallest of the three, currently holds just $200 million in assets.

HYG is a U.S. focused high yield corporate bond ETF. High yield bonds, also known as junk bonds because they carry below-investment grade issues, often trade more similarly to equity products than to treasury, agency or investment grade bonds. High yield bonds normally provide higher returns than corporate bond ETFs or aggregate funds because investors are taking on additional default risk, but the delta in late 2008 and early 2009 reached near-historic highs. Moody's expects default rates to be about 16% in 2009, worse than any time since (and possibly including) the depression in the 1930s. But junk bonds also pay 16-20% above Treasuries, which means that substantial default is priced in to these funds at these levels. HYG competes with SPDR Lehman High Yield Bond (NYSEArca:JNK), expense ratio 0.4% and the fundamental fund PowerShares High Yield Corporate Bond (NYSE:PHB), expense ratio 0.5%.

Bond investors need to think not only about credit risk and default risk but also interest rate risk, which is how a change in interest rates will impact the price of a bond portfolio. Bonds with a longer duration are more sensitive than bonds with a shorter duration. When interest rates come down, bonds with greater exposure to interest rates will outperform. When interest rates rise, bonds with greater sensitivity to interest rate risk will underperform. Interest rates, in turn, often react to inflation. When inflation kicks up, central banks like the Federal Reserve inevitably raise prime rates to banks who in turn raise interest rates for the public. With deflation expected to run its course during 2009, long-maturity bonds seem safe at the moment. But with so many dollars being printed, inflation could kick up by 2010 and force the Fed to raise interest rates. That would almost certainly weaken longer duration bonds.

Corporate bond ETFs are generally organized by asset mix rather than by duration. (This contrasts with treasury ETFs, which tend to be organized by duration). The aggregate bond fund BND has a slightly shorter duration (3.7 years) than AGG (4.2 years). CFT has a slightly shorter duration (5.9 years) than LQD (7.2 years). Shorter duration bond ETFs will likely outperform if interest rates rise. Though small differences in duration are less important to the performance of high yield corporate debt where default is all-important, any bond portfolio can be expected to suffer from higher interest rates.

Investors can no longer be sure that even high grade corporates will significantly hedge equity portfolio volatility in times of severe market stress. True, counterparty risk has moderated since the worst moments of the debt crisis. U.S. corporate bond ETFs have bounced back. But corporate debt correlation with broad equity market movement remains possible. In addition, new problems for corporate debt ownership may be on the horizon. The unprecedented U.S. monetary expansion in 2009 risks inflation in 2010 and beyond. If inflation happens, interest rate hikes cannot be far behind. Bond investors should be willing to pare down long-maturity bond holdings in favor of shorter maturities. Of course for those individuals who believe that current deflation will continue for the foreseeable future this should have little concern.

Following are a list of U.S. Corporate Bond ETFs according to the three categories outlined above:

Aggregate Bond (treasury, agency, MBS and corporate) ETFs:

iShares Barclay Aggregate Bond (NYSEArca:AGG)

Vanguard Total Bond Market (NYSEArca:BND)

SPDR Lehman Aggregate Bond (NYSEArca:LAG)

Investment Grade Bond ETFs:

iShares iBoxx Investment Grade Corporate Bond (PCX:LQD)

iShares Credit Bond (NYSEArca:CFT)

iShares Barclays 1-3 Year Credit Bond (NYSEArca:CSJ)

iShares Barclays Intermediate Credit Bond (NYSEArca:CIU)

High Yield Bond ETFs:

iShares iBoxx High Yield Corporate Bond (NYSEArca:HYG)

SPDR Lehman High Yield Bond (NYSEArca:JNK)

PowerShares High Yield Corporate Bond (NYSE:PHB)