The Treasury recently announced new rates for Series I savings bonds, or i-bonds. I-bonds purchased between now and October, 2023 will earn a composite interest rate of 4.30%. However, 0.90% of this composite rate is made up of a fixed rate. This fixed-rate only applies to new i-bond purchases. If you already own i-bonds from last year, your composite rate is actually lower than 4.30%. Declining inflation rates for existing i-bond holders may make i-bonds less attractive to hold onto. But rising fixed rates on new purchases mean they remain an appealing inflation-hedged investment for new money.

The fixed rate impact

I-bonds became extremely popular thanks to their 7-10% yields throughout 2021-2022. When we first recommended buying them in November of 2021, the rate was 7.12%. We doubled up on that recommendation after i-bond rates jumped to 9.68% one year ago. However, we warned last November that i-bonds may not be as good of an investment when compared to TIPS or regular Treasuries. At the time, the rate had fallen to 6.89% which included a 0.40% fixed rate.

I-bonds purchased between November 2021-October 2022 boasted high yields, but no fixed rate. The lack of a fixed rate means those i-bonds are yielding less than the 4.30% composite rate that the Treasury just announced.

Because the fixed rate stays the same for the life of the bond when purchased, i-bonds are arguably still attractive for new purchases. While the inflation rate that makes up the i-bond has fallen from 6.48% to 3.38%, the fixed-rate component has risen from 0.40% to 0.90%.

This means that i-bonds purchased today will earn a minimum of 0.90% per year for the next 30 years, plus any interest paid as a result of the inflation rate. While that 0.90% fixed rate is paltry compared to short-term treasury rates, it’s a higher coupon than the majority of Treasury-Inflation Protected Securities (TIPS) trading on the market. Back in November, when the fixed-rate portion of i-bonds was still just 0.40%, we suggested that TIPS were a better inflation-beating investment. That debate is more competitive today now that the i-bond’s fixed rate has more than doubled.

Should I sell old i-bonds?

For those holding onto i-bonds with a 0% fixed rate, the decision to hold or redeem is more complicated. At 3.38%, the annualized rate is 1.75% below the yield on six month treasury bills, which are, as of this writing, yielding 5.14%. However, if you were to sell an i-bond purchased within the last five years, you’d forfeit the last 3 months worth of interest.

We wouldn’t recommend forfeiting the last 3 months of interest on the 6.48% inflation rate from November 2022. But, after that 6-month window is up, it may make sense to forfeit 3 months worth of interest on the 3.38% inflation rate in exchange for buying 6-month treasury bills or new i-bonds with the 0.90% fixed rate built in.

It’s important to remember that your six month window is tied to your purchase date. For reference, this six month window refers to the semi-annual reset built into i-bonds. Consider the following table:

I-bond purchased in…	6 month window ends…
November 2021	April 2022
December 2021	May 2022
January 2022	June 2022
February 2022	July 2022
March 2022	August 2022
April 2022	September 2022
May 2022	October 2022
June 2022	November 2022
July 2022	December 2022
August 2022	January 2023
September 2022	February 2023
October 2022	March 2023
November 2022	April 2023
December 2022	May 2023
January 2023	June 2023
February 2023	July 2023

For example, i-bonds purchased in May 2022, earned 9.62% annualized through October 2022. Then in November 2022, that same purchaser started earning 6.48% through April 2023. A different person who bought i-bonds in September 2022 earned 9.62% annualized through February 2023. Then they started earning 6.48%, which will last until July 2023. That purchaser won’t see their rate decline to the new, 3.38% rate, until August of this summer.

Understanding when your six month window started is very important before considering if you should forfeit any interest. If you get your dates wrong, you could end up forfeiting a higher interest amount than you intended.

Final considerations

I-bonds that do not have a fixed rate are less attractive investments today compared to available rates in the marketplace. If you have ample liquidity, we’d recommend just buying 6-month treasury bills in the open market where yields are currently five precent plus. If you have money tied up in i-bonds that you want to free up for other investments, then make sure you wait until after you’ve spent three months inside the latest interest bearing window that is only paying 3.38%.

Forfeiting three months of interest at 3.38% is only 0.85%. At today’s treasury rates, you can make up that difference in the open market. But you need to judge where rates are three to six months from now before making a final decision. If you forfeit three months of interest at the 6.48% rate, which is still accumulating for many people, you’re giving up 1.62%. That’s a number you can’t get back in the open market today.

The math behind the inflation rate, and recent readings on inflation, suggest that i-bond rates likely drop further when the new rate is announced in October later this year. But, if inflation flares up again next year, that same math equation will propel i-bond rates back up, benefitting holders.

The bottom line is i-bonds with no fixed rate are less attractive than they were one year ago. But, due to the new, 0.90% fixed rate, which lasts for the life of the bond, new purchases may still be appropriate for some buyers. Please reach out to us if you would like to discuss your options.

Please note: In this article, we left out some details as far as “what are i-bonds?” — but we’ve covered the material in earlier pieces. You can learn more about i-bonds here, or here.

Series I savings bonds, or ibonds as they’re commonly referred to, are having a moment. The US treasury recently announced record sales for ibonds. The yield on ibonds is linked to the growth rate of inflation. Because inflation exploded higher starting in the summer of 2021, ibond yields have jumped accordingly. That’s why, one year ago, we recommended taking advantage of the increased yield and buying ibonds. We reiterated that call in May of this year after ibond yields jumped to more than 9%. However, now that ibond yields are falling they’re no longer the no-brainer investment they were earlier in the year.

How ibonds yield is determined

First, it’s important to remember that ibonds offer a variable interest rate that resets every six month based on the following equation:

ibond yield = [fixed rate + (2 x semiannual inflation rate) + (fixed rate x semiannual inflation rate)]

The Treasury recently set the fixed rate at 0.40%, up from 0.00%. The semiannual inflation rate is measured by the Consumer Price Index for all Urban Consumers (CPI-U). The CPI-U increased from 287.504 in March 2022 to 296.808 in September 2022, a six-month change of 3.24%. Therefore, we plug the fixed rate (0.40%) and the semiannual inflation rate (3.24%) into the equation and get a current yield of 6.89%:

So, investors who buy ibonds today are guaranteed to earn 6.89% for six months. That sounds pretty good… until we start to consider what the yield might be six months from now and annualize that out. And then compare that annualized ibond yield to current yields available from other risk-free treasuries. For example, if the yield on ibonds falls to 2% six months from now, then an annualized ibond yield looks like this:

(6.89% X 0.50%)+ (2% X 0.50%) = (3.45%) + (1%) = 4.45% annualized yield where the investor earned 6.89% for six months and then 2% for six months.

That hypothetical 4.45% yield for ibonds over the next 12 months is less than the current yield of 1, 2, and 3 year treasury bonds. So the key factor is in trying to determine what the ibond yield will be after the next reset on May 1st, 2023.

Projecting out to May 2023

The next ibond reset takes place on May 1st, 2023 and will be based on the CPI-U growth rate from September 2022-March 2023. September’s CPI-U came in at 296.808. Any March 2023 CPI-U reading below 296.808 will result in a negative growth rate for CPI-U. Thus, the semiannual inflation rate in the ibond yield equation would be 0% (the Treasury limits figures at 0% and will not use negative numbers). In that scenario, we would plug in the fixed rate (0.40%) and the semiannual rate (0%) into the ibond yield equation:

[0.0040 + (2 x 0.00) + (0.0040 x 0.00)] = 0.40%.

The ibond yield would fall to 0.40%! If we plug that into an annualized return… where we earn the current yield of 6.89% for six months and then 0.40% for six months after that, our annualized return is just 3.645%. Such a rate is substantially lower than yields currently available on every part of the treasury curve.

In order for the ibond yield to maintain its current 6.89% yield in May 2023 after the next reset, CPI-U needs to come in between 306-307 in March 2023. That would translate to 3.10%-3.40% growth in CPI-U versus the September 2022 CPI-U figure. If CPI-U comes in above 306 in March 2023, that would qualify for the highest CPI-U currently ever recorded. We believe the odds of that happening are low.

The chart below shows what the ibond yield will look like based on varying CPI-U readings in March 2023 (click here for an interactive chart):

Growth of inflation, not inflation itself

The key consideration with ibonds is that the future yield is based on the growth rate of inflation at a specific date. In this case, the March 2023 CPI-U figure versus the September 2022 CPI-U figure. Therefore, all of the CPI-U readings from October 2022-February 2023 are essentially irrelevant. Even if inflation figures continue to come in hot in the near term, but have subsided by March 2023, the ibond yield could fall towards 0%.

The Federal Reserve is projecting inflation to fall sharply in 2023. Other indicators we follow are also suggesting that inflation will moderate quickly in the coming months. Keep in mind, for ibonds, we could be stuck with all of the inflation we’ve already experienced and the yield could still fall towards 0%. Because, and we can’t emphasize it enough, the ibond yield is tied to the growth rate of inflation, not inflation itself. 

Our best guess is that inflation will stay stubbornly high, but that the growth rate of inflation will be slowing dramatically as we come up on high comparable figures. This makes ibonds a less than ideal investment right now.

Buy treasury bonds instead

People flocked to ibonds because of their safety and high interest rate. But that interest rate is likely heading lower. As an alternative, we recommend investors focus on Treasury bonds with maturities of 1-5 years. Such bonds are currently offering interest rates between 4.0%-5.0% and, unlike ibonds, your interest rate won’t change after you buy it. In addition, these types of bonds do not come with the $10,000 purchase limit that ibonds do. So you can invest much more of your money.

Lastly, the real yield on these types of bonds, that is, yield minus the inflation rate, has a chance of being positive. If inflation falls towards 3% next year as the market currently expects, treasuries will provide a real rate of return of 1-2% depending on the maturity. Ibonds will only guard against a negative real rate of return, but, by design, they cannot provide a meaningful positive real rate of return. If you want a more effective hedge against inflation than ibonds, consider TIPS, which are currently yielding 1-2% and offer payments that adjust with inflation.

Add it all up and our advice is simple: if you did not buy ibonds prior to the latest reset you are likely better off parking that money in treasuries or TIPS instead. Current clients can take advantage of our no-fee treasury only accounts if they would like assistance with these purchases.

Bond prices have fallen sharply this year, which has been a real pain for fixed income investors. However, with pain comes gain. Yields, which move inversely to prices, are now the highest they’ve been in years. This means that investors finally have some options when it comes to their fixed income portfolio. In addition, cash sitting in the bank can now earn something through extremely low risk investments. We’ll share some of the ETFs we’ve been buying recently that capture different areas of the bond market.

Where bond yields are now

Take a look at where bond yields were at the end of last year compared to where they are now:

These higher yields are widespread, meaning that bonds that are typically safe, and those that are typically risky, have seen a significant rise in yields.

VGSH, an ETF that tracks short-term treasuries with maturities between 1-3 years, is currently yielding 3.10%. At the end of last year, the yield was less than 0.75%. In other words, $10,000 invested in VGSH today can earn $310 over the next 12 months compared to just $75 at the beginning of the year. These types of treasuries are among the safest securities in the world. If you usually keep some cash idle in your portfolio, you may want to consider putting it into VGSH as a cash replacement.

Looking beyond treasuries, corporate bonds are offering their highest yields since prior to the 2008 financial crisis. IGIB is an ETF that tracks investment grade corporate bonds maturing in 5-10 years. IGIB’s current yield is 4.60% compared to 2.50% at the end of last year. IGIB is riskier than VGSH because corporate debt is not as safe as government debt, and it is more sensitive to changes in interest rates since it holds bonds with longer maturities. But that extra risk comes with additional compensation (4.60% yield vs VGSH’s 3.10% yield). In addition, IGIB’s price could provide some capital appreciation as well if interest rates move lower.

Should you “reach” for yield?

The area of the bond market that’s offering the greatest yield right now is high yield, or “junk” bonds. This typically refers to non investment grade corporate debt. A couple ETFs that track this segment of the market are USHY & SHYG. Both of these funds are yielding over 7%. The way these differ from safer bond funds isn’t as much their interest rate sensitivity, but rather how USHY & SHYG will react to sentiment shifts in the economy. If recession fears take hold, for instance, USHY & SHYG would be expected to sell off, even though interest rates may then move lower (and boost other, safer, bond funds). In that way, they function similar to stocks than they do traditional government bonds (though they are still less volatile than stocks).

Because of this, they should not be relied on as traditional ‘diversifiers’ in a portfolio the way higher rated bonds are. But, because of their attractive yields, they still make a lot of sense. One idea could be to pare back some equity exposure and replace it with high yield bonds. For example, if your portfolio is invested 70% in equities and 30% in bonds, you may change that to 65% and 35%, but make the extra 5% in bonds an allocation to high yield bonds through SHYG or USHY. The logic being that a 7% fixed rate may well outperform the S&P 500 over the next 12 months, especially if stocks spend time in a trading range.

Some super safe options

We’ve shared a few different ETF options for the market investor to consider. But attractive yields are also available outside of the market. High yield online saving accounts offered by Discover and Wealthfront are now offering 1.60% and 2.0% yields on cash, far higher than what your traditional big-brand bank is offering. While these are online only accounts, they are FDIC insured. In addition, Discover, Barclays, and Goldman Sacs are all offering 1-5 year CD rates between 2.25-3.25%. CD’s are FDIC insured and will not lose value.

This year has been one for the record books. Stocks and bonds suffered through their worst congruent decline in history. But now, with the dust settling, and stocks having already rebounded from their lows, there’s opportunities in bonds that investors may want to take advantage of. If you’re sitting on cash and wondering what to do? Well, you’ve already lost 8.50% in the last year due to inflation. Now, thanks to higher bond yields, you’ve got some options across the fixed income spectrum, both on the safer side, and riskier side.

Nassim Taleb has a famous quote that comes to mind with regards to the current market:

“To bankrupt a fool, give him information.”

Assuming we know how markets will respond to a given piece of information is a dangerous game. Consider what you would have predicted for the stock market in 2020 if in December 2019 you knew a global pandemic was about to shut down the economy three months later? Well, the S&P 500 rose 16% in 2020. Next, flashback to October 1963… someone tells you the President of the United States is going to be assassinated in one month… surely the market will crash then! Surprisingly, stocks rallied shortly after JFK’s death and went on to return 13% in 1964.

We never know what the future holds, so even though there’s no shortage of negative information right now, here’s three reasons to stay optimistic.

Stocks have done well following rough patches

The S&P 500 is down more than 10% through March 10th for just the eighth time in its history. Six of the last seven times that has happened, the S&P 500 performed very well through the rest of year, rising a median of 30%! The only negative occurrence was in 2008:

In addition, the NASDAQ made headlines recently as it officially entered a “bear market,” defined as a drop of 20% or more. Ironically, the NASDAQ has performed very well on three, six, and twelve month timeframes following the official start of a bear market. Often times, by the time the bear market officially begins, the worst of it is over!

Volatility may have peaked

Another reason for optimism is that volatility, as measured by the VIX index, may have peaked. The VIX index represents the market’s expectation of volatility over the next 30-days. The VIX is an index that anyone can keep tabs on, just like the S&P 500. Currently, it is around 31.

A high or low VIX means the market expects high or low volatility over the next 30 days. But what constitutes high or low for the VIX index? It can be subjective, but one popular notion is that a “high” VIX is anything over 20 and a “low” VIX is anything under 12. Anything between 12-20 is considered “normal.” In a high VIX environment, the S&P 500 will experience greater percentage changes on a daily basis. In a low VIX environment the S&P 500 will experience smaller percentage changes on a daily basis.

The VIX has been above 20 every day since January 18th, 2022. Since that day, the S&P 500 has fallen roughly 10%. Markets tend to fall as volatility rises and rally as volatility declines. The good news is that even though the S&P 500 is near its low for the year, the VIX is a good bit away from its January 24th high near 39.

Think of a toddler trying to recover from a temper tantrum, the first step is to calm down. Granted, the VIX is still high, but with it being lower now compared to January 24th, even with the market still declining, it’s a sign that the market is at least “calming down.”

Jobs data is still positive

Last month the unemployment rate fell to a new post-Covid low of 3.8%. This was a decline from 4.0% in January and below the prior post-Covid low of 3.9% in December 2021. This is important because the unemployment rate has flat lined or ticked higher before every single recession dating back to 1948.

In addition, the total number of job openings remain near record levels, indicating there is a lot of demand for labor in the jobs market. The total number of job openings peaked 8 and 15 months before recessions that began in December 2007 and February 2020, respectively. The latest data we have shows 11.3 million jobs open as of the end of January (a slight downtick versus December 2021 levels of 11.4 million).

We know the information

We know there is a terrible war going on in Ukraine right now. We know inflation is at 40 year highs. We know Americans are paying more for gas than ever before. We also know that there’s certainly things we don’t know! And even if we had access to that unknown information, it wouldn’t necessarily help us predict how stocks will perform.

Yet, with a decline of 12% so far to start the year, there’s a chance that many of the negatives (known or unknown) have already been priced in to the market, and we’ll choose optimism over pessimism any day of the week!

Looking for a clue as to when the current sell off in stocks will be over? Watch the bond market. Back in March 2020, it was a bottom in the bond market that helped put a floor under stocks. The bond market bottomed the week of March 16th, 2020 with stocks bottoming the following week (on March 23rd).

Looking back at March 2020

March 2020 is most famous for the fastest drop in stock market history. But the selling wasn’t just restricted to stocks. Bonds, a typical safe-haven during time of stock market stress, were routed as well. AGG, a diversified bond ETF that includes treasury bonds, mortgage-backed securities, and corporate bonds, fell 8% from March 1st, 2020-March 18th, 2020:

This was the fastest and largest drawdown on record at the time. However, AGG bottomed quickly, and by the end of month it was down less than 1% for the period:

This was an extremely important development at the time and helped alleviate concerns of a continued market melt down. The bottom in AGG on March 18th came ahead of a bottom in the S&P 500 (lower panel) the next week on March 23rd:

Looking at the current market

So far in 2022, we’re again seeing downward pressure in the bond market as represented by AGG, which is down nearly 4% year-to-date:

This decline negatively impacts diversified portfolios that are already suffering through year-to-date losses from their stock market allocations. So we’re again watching for a bottom in AGG as a potential leading indicator that the current decline in the S&P 500 is nearing its end. What would a bottom in AGG look like? Watch for a thrust higher (+1% in a single day would qualify) that doesn’t return to its low in the following days.

We will especially take note if the S&P 500 moves below its year-to-date low of 4,222 but AGG does not move under $109. Such a scenario would look like a similar set up to the stock market bottom from March 2020. While no one can predict when or where stocks will bottom, that doesn’t need to stop us from looking for clues. And we believe a bottom in AGG would be a positive for stocks.

Preferred stock ETFs make up a healthy chunk of our fixed income portfolio. We like them for their high income characteristics and lower volatility compared to the S&P 500. They are especially attractive in IRA accounts, where 100% of the yield is earned, tax free. Given that equity market returns are expected to be lower in the years ahead, the case for preferred stock ETFs is very compelling.

The case for preferred stock ETFs

As the stock market has provided solid and steady returns for much of the last year (and decade), concern is building that future returns will be lower. Vanguard, for example, projects that the US stock market will return between 2.5-4.5% annualized over the next 10 years:

If Vanguard’s projections are accurate then those returns would be below the current yield of the two preferred stock ETFs we invest most heavily in: PFXF & PFFD, which currently yield 4.86% and 4.81%, respectively. That means that a $10,000 investment in either ETF will receive ~$480 in dividend payments over the course of the next year. What’s nice about these ETFs, is that unlike traditional dividend paying stocks, they make distributions monthly, not quarterly.

What about owning dividend ETFs?

Investors often take unnecessary risk when choosing to invest in high dividend ETFs in hopes of capturing a high yield. Data suggests that high dividend ETFs tend to underperform the S&P 500 as a whole while proving to be more volatile than the index itself.  That’s a poor combination. If you’re going to take on added volatility, you should be compensated with a higher rate of return.

Take SPYD, which is SPY’s high dividend companion, in the last three years it has lagged the return of the SPY by 40%! Furthermore, it has trailed the return of our preferred stock ETFs as well:

What have you gotten in exchange for that (relatively speaking) terrible performance? Significantly higher volatility! When comparing SPYD to SPY or our two preferred stock ETFs, SPYD has experienced the highest volatility of the group by far over the last five years (note: SPYD began trading in 2015):

Remember, a high dividend payout does nothing for you if the payout is offset by share price volatility.

Using IRAs to earn tax-free income

IRA accounts offer a major advantage for income investors in that all of the income is earned tax-free. Let’s look at an example for a married couple earning $200,000 per year. PFXF pays 4.85%… for our married couple to get that same yield, after-tax, they would need to earn 6.66% (nearly 40% more). So if you’re a high earner, you may consider preferred stock ETFs to be especially valuable inside of IRA accounts.

In summary, when constructing your portfolio make sure you consider the benefits of preferred stock ETFs. A few of our favorites are PFFD, PFXF, PFF, and VRP. If future returns for stocks are lower, then preferred stock ETFs could outperform the S&P 500, especially on a risk-adjusted basis. Be cautious about high-dividend ETFs as a source of income, they don’t have a great track record. Lastly, make efficient use of preferred stock ETFs by including them inside of IRA accounts, where 100% of the yield will be earned.

TIPS, or Treasury Inflation-Protected Securities, have had a strong run over the past few years. But going forward, we see the risk/reward case for investing in TIPS as murky, and we see some alternatives like preferred stock ETFs and high yield corporate bonds as potentially better investments.

In this piece we’ll talk a bit about what TIPS are, why they’ve done so well, and why a risk-reward analysis makes the case for seeking out some alternatives to TIPS going forward.

What are TIPS?

TIPS are first and foremost U.S. Treasury bonds. This makes them a very safe investment, as they are supported by the U.S. government and its implicit “never fail” backing. But fixed-income investors seek more than just safety with their bond purchases – they also want at least a modest income (coupon) payment, and the potential for some pricing upside.

As the name suggests, TIPS are designed to offer protection against the rising prices that inflation brings. The principle amount (face amount) of a TIPS bond is indexed to the Consumer Price Index, so that when the CPI rises, the principle amount of a TIPS bond rises by the same amount. The coupon interest rate on a TIPS bond will be lower than a vanilla Treasury bond with the same maturity. But if inflation occurs (via a rising CPI), then that lower coupon payment will be paid on a larger face amount as the principle value of the bond rises in lockstep with the CPI.

TIPS are issued with maturities of 5, 10, and 30 years. The first TIPS were issued by the U.S government in 1997, and have been very popular with investors ever since. At maturity, a TIPS bond pays out either the original face amount of the bond at issuance, or the updated principle after adjusting for inflation, whichever amount is higher.

Why TIPS Have Performed So Well

It sounds paradoxical, but TIPS have performed well in recent years not because inflation has been high but because it’s been low! In this sense, TIPS have done well for the same reason all treasury bonds have done well. Interest rates have remained low and trended lower for several years, which is bullish for bonds, including TIPS. Though we should note, while TIPS have performed well, they haven’t done any better than a vanilla bond fund like AGG.

Consider the curious case of why in the past 2 months, when actual, real-time inflation is rising much faster than the market expected, TIPS are flat or falling. This is a reflection of how expectations of something in the future can be priced into a security early on.

The TIPS Spread and Inflation Expectations

The spread between the yields on TIPS bonds and regular Treasuries with the same maturity is a highly watched metric, as it shows how much inflation the market is expecting over the remaining years until both bonds mature.

The issue we have with inflation expectations via this chart – which has inflation topping out at 2.5% then retreating – is this: If real-time inflation is running at over 4%, who’s wrong – the market or the actual data? If the market’s expectation (of inflation running no hotter than 2.5% in future years) is too low, then TIPS could sell off rather dramatically in the near-term. This would create more volatility than we want for our clients. Meanwhile if the data ends up being wrong, if the market is right about “transitory inflation,” then TIPS will stay about the same, while paying below-market yields to holders. It will take a long-lasting surge in inflation above 4-5% for TIPS to offer meaningful upside from here.

History also gives us some valuable clues about how TIPS react when prevailing rates are already low, and the market suddenly becomes concerned about the Fed removing accommodation/stimulus measures. The so-called “taper tantrum” in the summer of 2013 happened when the Fed discussed tapering away from the quantitative easing that was put in place to help us out of the Great Recession of 2008-09.

What ensued was the worst 3-month performance bout for TIPS ETFs in the last decade. Many of the same variables could be in place now, further souring our near-term outlook for TIPS.

Alternatives For Inflation Protection

One rather obvious way to combat higher inflation is to seek out higher yields. We must consider the extra credit risk involved when “reaching up for yield”, but one area we like is high-quality corporate bonds that mature in the next 5-10 years. The iShares 5-10 Year Investment Grade Corporate Bond ETF (IGIB) meets this criteria well, and has an ultra-low expense ratio of just 0.06%.

While one could argue for moving even shorter down the curve, we think the 5-10 year range is appropriate given that we don’t expect extreme inflation to be long-lasting. Investment grade corporate bonds have an extremely strong risk profile – though yes, they’re still riskier than treasuries. Corporate balance sheets are in the best shape they’ve been in for many years and the economy is forecast to leap over 6% higher in 2021.

Another ETF we think can do well in a higher inflation regime is HYEM. HYEM is a high yield emerging market bond ETF that has a duration of less than 4. This means it’s not super sensitive to changes in interest rates but it boasts a yield of almost 5%.  And lastly, we would expect gold, which hasn’t performed well so far in 2021, to fare much better in the future if inflation does prove to be persistent.

Investment grade corporate bond ETFs are a key pillar of our fixed income portfolios. One of the most popular such ETFs is Blackrock’s LQD ETF, which boasts over $40 billion in assets. LQD offers broad exposure to the investment grade corporate bond market. Another ETF from Blackrock, IGIB, is similar except that it only owns bonds with maturities between 5-10 years. IGIB is a popular choice in its own right, as it has over $11 billion in assets, but that’s still far less than LQD. We’re going to explain why we’ve been increasing our exposure to IGIB and reducing our exposure to LQD.

The similarities & differences

First, it’s important to understand that there is a lot more in common between LQD and IGIB then there is differences. Both track indexes composed of U.S. dollar-denominated investment-grade corporate bonds, with very similar sector exposures, and credit ratings. In other words, one ETF isn’t riskier than the other in terms of concentrated sector exposure or having significantly lower credit quality. Both ETFs are also super liquid, making them very easy to buy and sell. So then what’s the difference?

The difference between these two ETFs is all about the maturities of the bonds they hold. IGIB targets bonds with a specific maturity between 5-10 years. LQD doesn’t target a specific maturity. As a result, IGIB’s bond holdings have an average weighted maturity of 7.5 years versus 13.80 for LQD. This is important because it makes IGIB less sensitive to changes in interest rates than LQD. (In general, longer-dated maturities are more sensitive to interest rate changes than shorter-dated maturities.

Looking at duration & yield

A bond fund’s sensitivity to changes in interest rates is called duration risk. This risk is always highlighted on ETF sponsor websites. Below, we can see the comparison of IGIB’s duration to LQD’s duration: 

IGIB has an effective duration of 6.48 compared to 9.65 for LQD. What this means is that if interest rates rise 1%, IGIB’s price would fall 6.48% and LQD’s price would fall 9.65%. Conversely, if interest rates fell by 1% then IGIB’s price would rise by 6.48% and LQD’s price would rise by 9.65%. So LQD’s duration is almost 50% greater than IGIB’s. In exchange for taking on greater interest rate risk (higher duration), bond holders typically demand more return, or yield. However, you’ll notice the yield on LQD is 2.30% versus 2.07% for IGIB. That’s just 11% more yield for LQD than IGIB. So for taking on 50% more interest rate risk as measured by duration, investors in LQD are receiving 11% more in yield. That doesn’t seem too favorable to us.

IGIB must be less credit worthy

Typically when we see a scenario like this, where you can trade down in interest rate risk without giving up much in yield (i.e. selling LQD to buy IGIB), we suspect we must be taking on greater risk somewhere else, such as in credit quality. But if we compare IGIB’s credit quality to LQD, it’s very similar, with a small advantage in favor of LQD’s credit quality:

LQD has 3% more bonds rated AA and IGIB has 5.50% more bonds rated BBB. Put simply, IGIB has a little more credit risk than LQD. However, in evaluating the total holdings of each fund, there is over 90% credit rating overlap, meaning a vast majority of each of the fund’s holdings are rated the same. In essence, going from LQD to IGIB only increases our credit risk slightly.

In conclusion, we would recommend IGIB over LQD at this time for core investment grade corporate bond exposure. By investing in IGIB instead of LQD we are able to lower our interest rate risk significantly. The trade off is only slightly less yield and slightly worse credit quality. In a rising rate environment, where economic growth is strong, interest rate risk is our number one concern. As a result, we think the case is pretty compelling in favor of IGIB over LQD.