Bond ETF

Bond ETF

With more than 700 different CUSIPs

How would you like to invest in a diversified $17.6 billion investment grade corporate bond fund with an incredibly low expense ratio of just 0.15%, a trailing 12-month yield of 4.41%, and over 700 different holdings? Roughly 70% of its holdings have less than 10 years to maturity, and the fund holds positions in well-recognized and generally respected companies such as 3M (MMM), Berkshire Hathaway (BRK.B), Coca-Cola (KO), International Business Machines (IBM), and Procter & Gamble (PG).

On the other hand, perhaps you would be interested in a corporate bond fund with an average maturity of 11.78 years, a 30-day SEC yield of only 3.91%, and more than one-quarter of its holdings with more than 20 years to maturity. The fund even has a massive 35.74% exposure to financials, including the European banks BNP Paribas, Deutsche Bank (DB), HSBC (HBC), and Barclays (BCS).

As you might be guessing, these two descriptions are each of the same fund, the iShares iBoxx $ Investment Grade Corporate Bond Fund, better known by its ticker symbol, LQD. LQD is an exchange-traded fund with underlying holdings in investment grade corporate bonds. These are bonds/notes with Moody’s and S&P ratings above Baa3/BBB- respectively. Ratings below Baa3/BBB- fall into the non-investment grade category for which iShares offers its high-yield ETF, (HYG).

It may be tempting to jump into LQD simply because of its investment-grade label, nearly 4% yield, and the belief that a well-diversified bond fund will better shield you from counterparty risk. However, performing a bit of due diligence is a beneficial exercise for those investors wishing to discover what exactly they would have exposure to by owning the LQD, and whether there are any possible stumbling blocks in the fund’s holdings that an investor might want to avoid. With this in mind, let’s take a brief look at the iShares iBoxx $ Investment Grade Corporate Bond Fund LQD.

With an inception date of July 22, 2002, LQD has been around for nearly ten years. It attempts to track the performance of the iBoxx $ Liquid Investment Grade Index. Since the fund’s inception through January 13, 2012, the LQD has returned 77.87% (including distributions), whereas the index returned 82.54%. When factoring in LQD’s expense ratio of 0.15% to the equation, the 4.67% underperformance since inception doesn’t appear as bad. However, despite the benefit of adding the expense ratio back into returns, when a fund trails the benchmark on an average annual basis by roughly twice the expense ratio, it certainly leaves something to be desired. This is especially true in a zero-interest-rate-policy world. If you would like to view a chart highlighting the tracking error of the LQD, please visit the fund’s webpage on iShares.com.

Recently trading at $114.51, LQD has average volume over the past 90-days of approximately 1.5 million shares per day. As of January 12, 2012, the fund held 98.37% of its assets in bonds, 0.13% in cash, and 1.49% in a category marked “other.” In terms of yield, LQD’s 30-day SEC yield is 3.91%, and its trailing 12-month yield is 4.41%. According to iShares, the trailing 12-month yield is calculated by “summing any income distributions over the past twelve months and dividing by the sum of the most recent NAV [net asset value] and any capital gain distributions made over the past twelve months.”

With regard to credit quality, this investment grade bond fund holds most of its assets in bonds rated somewhere in the six ratings that span the Aa3/AA- to Baa2/BBB categories of Moody’s and S&P. The Moody’s ratings are Aa3, A1, A2, A3, Baa1, and Baa2; the S&P ratings referred to above are AA-, A+, A, A-, BBB+, and BBB. Approximately 80% of the LQD’s assets are invested in securities with one of the aforementioned Moody’s or S&P ratings.

In general, Aa ratings by Moody’s represent obligations of “high quality and are subject to very low credit risk,” A ratings are considered “upper-medium grade and are subject to low credit risk,” and Baa ratings are considered medium grade obligations, are “subject to moderate credit risk,” and “may possess certain speculative characteristics.” From S&P’s perspective, AA issuers have a “very strong capacity to meet financial commitments,” A issuers have a “strong capacity to meet financial commitments, but [they are] somewhat susceptible to adverse economic conditions and changes in circumstances,” and BBB issuers have “adequate capacity to meet financial commitments, but [they are] more subject to adverse economic conditions.”

It should also be noted that despite being labeled as an investment grade fund, LQD has investments in Ba1/BB+ rated and BB rated bonds, all considered below investment grade. Ba1 rated bonds comprise 1.22% of net assets, and BB+ and BB bonds make up 0.22% of net assets. While examining the fund’s holdings, I also noticed what appears to be six trust preferred securities, four for JPMorgan Chase (JPM), one for Goldman Sachs (GS), and one for Wells Fargo (WFC). In total, they make up 0.27% of net assets.

Just over 70% of the fund’s assets are invested in securities with one to ten years to maturity, and another 22.51% of assets are invested in securities with 25 years or more until maturity. Regarding the breakdown by sector, there is a good deal of diversity in terms of the number of sectors represented in the fund. However, just three of the 10 sectors, Financials, Consumer Services, and Oil & Gas make up 58.74% of the fund’s assets. Financials alone make up 35.74% of the fund’s assets, and Consumer Services and Oil & Gas comprise 12.50% and 10.50% of net assets respectively. The other seven sectors to which LQD has exposure are Telecommunications, Consumer Goods, Health Care, Technology, Industrials, Basic Materials, and Utilities.

The huge exposure to financials should not be downplayed. It not only represents more concentrated exposure than many fixed income investors may be looking for, but it is also noteworthy for holders of financial stocks looking to diversify into fixed income. If you already own the stocks of JPMorgan Chase, Bank of America (BAC), Morgan Stanley (MS), Goldman Sachs, and Citigroup (C), for example, whether individually or through an ETF like the Financial Select Sector SPDR ETF (XLF), you will need to think about whether LQD is the right way for you to diversify into fixed income.

When looking beyond the sector breakdown, an investor finds significant diversity in terms of the quantity of the underlying holdings of LQD. With more than 700 different CUSIPs (identifier for a bond, similar to an equity symbol for a stock) across roughly 175 corporations, the top holding (CUSIP) in the fund being only 0.69% of net assets, and the top ten corporate bonds being only 5.89% of net assets, the fund is certainly not concentrated in its exposure to individual bonds.

However, in terms of its risk to any one company, it is possible to find a relatively small percentage of the roughly 175 corporations making up a decent size of total net assets. Here are some examples:

As you can see from the table, the bonds/notes of just ten companies, representing just 5.7% of the total number of companies in LQD, make up 24.70% of net assets. That’s much more concentrated counterparty risk than an investor might have realized had he or she only looked at the number of individual holdings (by CUSIP) in the fund.

On a closing note, as of January 12, 2012, of the 739 different CUSIPs in the LQD, only 103 had market prices under par (100 cents on the dollar). Of the 103 CUSIPs trading under par, only 9 were trading under 90 cents on the dollar. Of the 636 CUSIPs trading at par or higher, a whopping 365 were priced at 110 or higher, and 55 were even above 130 cents on the dollar. The lowest market price on the list belonged to a SLM Corp. note (0.04% of net assets), maturing August 1, 2033 and priced at 75.65 cents on the dollar. The highest market price in the LQD belonged to a Verizon Communications note (0.12% of net assets), maturing March 1, 2039 and priced at 159.86 cents on the dollar.

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