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Risks Facing Corporate Bond ETFs

This article was originally published on ETFTrends.com.

An often discussed topic among corporate bond investors last year was what would become of BBB-rated investment-grade debt in 2019. Bonds with BBB ratings are one to three notches away from junk status and BBB-rated debt accounts for a significant percentage of the U.S. corporate bond market.

The iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD), the largest investment-grade corporate bond exchange traded fund, devotes about 51 percent of its weight to BBB-rated debt.

LQD seeks to track the investment results of the Markit iBoxx USD Liquid Investment Grade Index composed of U.S. dollar-denominated, investment-grade corporate bonds. LQD allocates 95 percent of its total assets in investment-grade corporate bonds to mitigate credit risk.

This segment of the bond market also typically experiences less credit risk as they are issued by high-quality companies with credit ratings between AAA and BBB-. Nevertheless, they do come with the potential to default so they offer a higher yield than similar maturity U.S. Treasuries. LQD is also a favorite among institutional investors.

BBB Risks

Historically, investment-grade corporates with BBB ratings perform relative to other corners of the corporate bond market, but those bonds delivered losses last year, heightening concerns about fragile grasps on investment-grade ratings heading into 2019.

“What happened is that the spread, or gap, between the yields on BBB bonds and 10-year Treasuries got unusually tight a year ago and has now widened, with corporate yields rising and prices, which move in the opposite direction, falling,” reports Kiplinger. “That repricing of debt is the primary reason for 2018’s fizzle.”

LQD holds about 1,950 bonds with an effective duration of 8.28 years. While last year was hard on investment-grade corporate debt, recent equity market volatility may prompt investors to seek refuge under the umbrella of investment-grade corporate bonds again. As a result, high yield has underperformed lately as investors flocked to the safer confines of investment-grade debt issues. Still, risks linger for BBB corporates.

“But bonds rated BBB, the lowest quality considered better than junk, account for half of all investment-grade debt by dollar volume, a proportion that has grown nonstop from 10% in the 1980s,” according to Kiplinger. :The market shares of AA and AAA bonds have shrunk accordingly; single-A bonds have held steady at about 35%.”

For more trends in fixed income, visit the Fixed Income Channel.