Blue HavenBonds

Corporate bond ETFs insights: swap IGIB for LQD

By June 21, 2021 No Comments

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.

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