Seven Sigma Rally In LQD: Be Careful Where You Reach For Yield
With 'safe-haven' yields at extreme lows (and negative in some cases), there is sense in 'reaching for yield' but - obviously - any increase in yield implies an increase in risk (and just because it is called a 'bond' doesn't mean its safer than an 'equity'). By way of example, moving to investment grade credit is the 'strategy du jour' of many asset allocators - "a little more yield and it's still IG after all." However, while this is a decent safety strategy overall - in a diversified and actively managed credit book, falling for the easy route of buying the liquid IG bond ETF LQD may run some into problems - no matter how much its 'price' tracks Treasuries. The last month has seen LQD experience a 7-sigma rally and it stands at multi-month rich levels to its intrinsic value (which implicitly places technical bids in the cash market). What worries us the most about LQD specifically is, we suspect retail investors who are piling in are unaware of the exposures within the portfolio of bonds. LQD is 24.3% weighted in financials - the very same Libor-rigging, beached-whale, NIM-compressing financials that are anything but 'risk-free'. As a reminder, an old adage from credit portfolio management, "the loss from losers far exceeds the gains from winners" and at these levels of price (and therefore yield) there is a lot of convexity in that risk-reward. Understanding the credit risk you are taking is key.
LQD trades very rich to intrinsics (lower pane) and has experienced an extreme rally in the last month or so...
and as is clear, shares outstanding have surged as investor interest in the 'safety' of the investment grade credit market has surged BUT with a 24.3% weighting in financials - just how safe is this ETF?
IG bond prices will track well with overall interest rates UNTILl there are events and those events will likely be centered around financials - whose credit risk is near its recent highs.
Critically, when you buy LQD or any IG bond ETF, you are buying the credit risk of the portfolio - that is what accounts for most of the difference in performance (and yield) from straightforward Treasuries - seems obvious but sometimes we wonder. The key point being - do investors understand the credit risk they are taking?
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