Good Times for Corporate Bond ETFs

Jonathan Bernstein, Contributing Editor
October 30, 2010

It is the best of times for corporate bond issuers. It's a pretty good time for corporate bond ETF investors too. But investors should avoid the temptation to buy investment grade corporate bonds and corporate bond ETFs now. The yields are too low and the risks are too high.Investment grade corporate bond ETFs, like the bonds they hold, are currently trading on interest rates. Interest rates are low and the expectation is that they will stay low.Corporations are taking the situation as an opportunity to issue a lot of debt. Companies like Microsoft that have traditionally eschewed debt are getting in on the act. The yields on this new debt are very low. The most recent is Wal-Mart's three-year and five-year debt offering at rates of 0.75% and 1.5% respectively. Less worthy companies like Pepsico and even eBay are forced to pay more. But not much more. Ebay is offering just 0.875 percent on its 3-year notes. This is better than the plain vanilla money market account and U.S. treasury bonds, but not by much.At these levels, corporate bonds are pricing in very little risk from all this new supply. They are pricing in little default risk, little liquidity risk, and in fact very little interest rate risk. The 5-year chart below shows the historical returns of corporate bond ETFs and treasury bond ETFs. It compares the return of the high grade corporate bond LQD with a benchmark treasury bond ETF, the iShares Barclay 7-10 Year Treasury Bond fund (NYSEArca:IEF - News). LQD holds corporate bonds. IEF holds treasury bonds. The chart shows the price of these two ETFs tracking closely from September 2005 to September 2007. During this period, default rates crept lower. Corporate bond ETF investors were unworried about defaults. Corporate bond ETFs traded primarily on interest rate risk. This is the risk of higher yields for all fixed income products, causing the value of existing bonds to fall. During this period rates were trickling lower too, causing bond prices to rise slowly.Things changed mid-September 2007 after the Lehman Brothers collapse. In order for corporate debt to be attractive it must pay a higher yield than U.S. government debt. The reason for this is that corporate debtors sometimes default. The U.S. government presumably will not default. (It can print money to fulfill debt obligations. Corporations, as solid as they may be, do not pay in their own currency). Following the Lehman collapse, interest rate risk did not immediately change. But corporate bonds, like those held in LQD, seemed more likely to default. Also during this time, the bonds held in LQD faced liquidity problems due to seized up markets. Meanwhile, the market for treasury bonds was and remains among the most liquid in the world. LQD and IEF diverged.To try to get the economy back on track, the Federal Reserve sharply dropped interest rates. This boosted the price of bonds. It helped both the treasury bonds held in IEF and the corporate bonds held in LQD. The Fed policy flooded the markets with liquidity. Liquidity risk for bonds in LQD ebbed. The risk of corporate bonds defaulting did not go away, but it moderated. From the Fall of 2008 through the Fall of 2009, the divergence of the previous year corrected.Since the Fall of 2009, investors have pushed aside default risk and liquidity risk. The focus is mainly on interest rates. Lower interest rates helps both LQD and IEF. The two have resumed similar paths.Investment grade bond ETFs have only small positions in the lowest yielding bonds, like Microsoft and Walmart. They mostly have longer average maturities and therefore higher yields than the short term corporates. LQD currently yields about 5%. It has an average maturity of 12 years. iShares Barclay's Credit Bond fund (NYSEArca:CFT - News) yields about 4.5%, average maturity of 10 years. iShares Lehman 1-3 Year Credit Bond(PCX:CSJ - News), the safest of the three, pays just 3% and has an average maturity of about 2 years.The main risk to ownership of investment grade corporate bond ETFs is the direction of interest rates. The Federal Reserve is easing. Inflation may be the result. If higher rates follow inflation then corporate bond yields will rise and bond prices will fall. If the Fed allows inflation without raising interest rates, the meager returns of bond ETFs will just be eaten away.Following are U.S. Investment Grade Corporate and Aggregate Bond ETFs:Investment Grade Bond ETFs:iShares iBoxx Investment Grade Corporate Bond (NYSEArca:LQD - News)iShares Credit Bond (NYSEArca:CFT - News)iShares Barclays 1-3 Year Credit Bond (NYSEArca:CSJ - News)iShares Barclays Intermediate Credit Bond (NYSEArca:CIU - News)Aggregate Bond (corporate, agency, MBS, treasury) ETFs:iShares Barclay Aggregate Bond (NYSEArca:AGG - News)Vanguard Total Bond Market (NYSEArca:BND - News)SPDR Lehman Aggregate Bond (NYSEArca:LAG - News)iShares Barclays Interm Government/Credit Bond (NYSEArca:GVI - News)iShares Barclays Government/Credit Bond (NYSEArca:GBF - News)Jonathan Bernstein has been writing about ETFs since 2003 and is the author of Sector Trading: A Year in Exchange Traded Funds.