Sunday, February 22, 2009

Corporate Bond Deception Point

I never really understood the allure of corporate bonds. To me, it seems that corporate are simply a hybrid of equity and Treasury bonds. If Treasuries yield 6% and stocks grow at a 10% rate, corporates will yield something in between. Where in between depended on how much extra risk you were taking.

For years, corporate performed fabulously well. Investors got their above Treasury rate return with very few defaults. But this false sense of security did not last long. In the 18 months, many highly rated companies, such as the major financial institutions have seen their bond value sink as the risk of default surges. As a result, corporate bonds acted more like equities than Treasuries.

Let us look at LQD, the iShares iBoxx Investment Grade Corporate Bond ETF. The LQD has an effective duration of 7.16. By comparison, the IEF, which is the iShares Barclays 7-10 Year Treasury ETF, has an effective duration of 6.98. Nearly the same so a very good comparison.

Let's start by looking at the chart since LQD started trading 2002.

As you see, LQD rises pretty steadily for the first five years, outpacing the steady rise in the IEF, as expected. But when the stock market starts falling in late 2007, the LQD stops rising while the Treasury rally picks up steam. In the fall of 2008, corporate bonds crash nearly 20% before recovering most of the losses whereas Treasuries surged higher. All of a sudden, corporate bonds were acting more like stocks than Treasury bonds.

I think we can break this up into two periods. The first, July 2002 to June 2007, the LQD tracked the IEF very closely. In this period, LQD has a 93% correlation with the IEF but a negative 10% correlation to the SPY.

But from July 2007 to January 2009, the LQD shifted away from tracking Treasuries and towards stocks. In this second period, the correlation between LQD and IEF dropped to 56% while the correlation with the SPY rose to 38%.

Looking at that first period, we see that IEF had a total return of 32% while the IEF returned 21% and SPY rose 79%. To mimic the LQD, one could have put 80% of their portfolio in the IEF and 20% in the SPY. In the second period, the LQD fell 0.7%, not bad at all. But the 80/20 portfolio would have actually gained 9.3%.

During the entire period, LQD had an average annual return of 4.7% with a 9.3% standard deviation. On the other hand, the 80/20 portfolio returned a larger 5.3% with a standard deviation of just 5.9%.

Seems to me, that corporates are a bad deal for long term investors or for people relying on them for retirement income. The LQD though may be a great trading device for those who can predict when and how the correlations will change.