LQD: Low-Risk Fixed Income Investment Choice – iShares iBoxx $ Investment Grade Corporate Bond ETF (NYSEARCA:LQD)

ETF Overview

The iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD) focuses on long-term investment grade corporate bonds in the United States. The ETF tracks the Markit iBoxx USD Liquid Investment Grade Index. The index screens out corporate bonds that have maturity below 3 years. LQD has very low credit risk, as all of the bonds in its portfolio are investment grade. Hence, it offers investors good protection in an economic downturn. Unfortunately, the fund has much higher interest rate risk due to the fact that its portfolio of bonds has a very long average duration to maturity. The ETF offers a 3.5%-yielding dividend. It is a good investment choice for conservative investors with a long-term investment horizon, as it offers an average annualized return of 5.4%.

Data by YCharts

Fund Holdings

LQD’s portfolio consists of nearly 2,000 investment grade corporate bonds. This means that the ETF is not overly exposed to one single bond, as no single bond represents over 0.4% of its total portfolio (see table below).

(Source: iShares website)

In terms of issuers, no one single issuer represents over 3% of the entire portfolio (see table below).

(Source: iShares website)

Fund Analysis

Low credit risk

LQD only holds investment grade bonds. We like this strategy, as investment grade bonds have much lower default rate than high yield bonds. In fact, investment grade bonds’ default rate is only about 0.10% per year (based on the 32-year period measured). On the other hand, the average default rate for non-investment grade bonds is about 4.22% per year. This is the major reason why LQD can perform better than non-investment grade bonds in an economic recession. Although credit risk is low for LQD, investors should keep in mind that nearly 50% of the funds are BBB rated bonds (see chart below). BBB rated bonds are at the lower end of the investment grade credit spectrum.

(Source: iShares website)

High interest rate risk

As mentioned earlier, LQD’s average maturity duration is about 12.84 years. The long average maturity term means that the fund’s performance could be sensitive to interest rates. As can be seen from the chart below, LQD’s fund performance is inversely correlated to the 10-year treasury rate.

Data by YCharts

Reasonable management expense ratio

LQD has a reasonable management expense (MER) ratio of 0.15%. This MER is higher than the Vanguard Total Corporate Bond ETF’s (VTC) 0.07% but comparable to the Goldman Sachs Access Investment Grade Corporate Bond ETF’s (GIGB) 0.14%.

A 3.5%-yielding dividend

Investors of LQD will receive dividends with an annualized yield of about 3.5% on a trailing 12-month basis. This dividend is safe, as these are investment grade bonds with a very low default rate.

Data by YCharts

Macroeconomic Analysis

The current economic cycle is well into its 10^th year. Nevertheless, there are already many signs that we are already in the late-cycle environment. For example, the treasury yield (10-year minus 2-year) is now near the point of inversion (see chart below). As can be seen from the chart below, yield inversions (when the 10-year yield minus 2-year yield falls below 0%) often precede economic recessions.

(Source: Federal Reserve Bank of St. Louis)

Besides yield inversion, we are also seeing signs of investors rotating from riskier assets (e.g., energy, industrial, etc.) towards defensive sectors (e.g., telecom, utilities, REITs, etc.). This equity rotation is often a sign of a late-cycle environment. Since LQD holds only investment grade bonds, it is considered a defensive fund. In fact, the fund price has appreciated by about 7% since the beginning of this year. Since we are already in a late-cycle environment, we think ETFs such as LQD will be a better choice of investment, as these funds have much lower credit risks. Therefore, we think investors can continue to hold on to LQD in an economic recession.

Investor Takeaway

For investors with a long-term investment horizon, LQD may not be a bad choice, as it has generated an average of 5.4% annual return since its inception and 6.7% annualized return in the past 10 years. Although this is not bad, we actually prefer the Vanguard Long-Term Bond ETF (BLV), as it has offered an annualized return of about 7.1% in the past 10 years. Unlike LQD’s 100% exposure to corporate investment grade bonds, BLV’s portfolio is roughly split between corporate and government-issued investment grade bonds. Therefore, it offers better protection in an economic downturn than LQD.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.

Additional disclosure: This is not financial advice and that all financial investments carry risks. Investors are expected to seek financial advice from professionals before making any investment.