A High Yield in a Safe Place
Talk about some serious volatility.
The past two years have been some of the most hectic ever — on both the downside and the upside. Meanwhile, if you’re trying to escape the ups and downs in some of the typical safe-haven investments, you’re being paid next to nothing.
One-year CDs pay a little over 1% a year. Three-year CDs pay less than 2% annually. Not even for taxes or inflation, a one-year CD would take 61 years to double your money at these rates.
You might think there’s nowhere to earn a solid return if you can’t stomach a volatile market. But I’ve found an answer — the opportunity in high-quality bonds.
Specifically, I’m talking about investment-grade corporate bonds; those with credit ratings of “BBB” or higher by Standard and Poor’s. The average credit spread (the difference in yield versus 10-year Treasuries) for investment-grade bonds as a whole is at about 240 basis points, which is well above the historical average of 151 basis points.
Their high credit ratings indicate a strong ability to pay debt and thus, lower risk. Yet, the higher-than-usual spread indicates it might be a decent time to buy for risk-averse investors. In particular, I’ve been looking at one specific fund.
The iShares iBoxx $ Invest Grade Corp Bond Fund (NYSE: LQD) is an exchange-traded fund that invests in a diversified portfolio of investment-grade corporate bonds.
LQD is a great way to play investment-grade bonds for a couple of reasons. First, since the ETF invests in a broad and diversified portfolio (474 issues as of July 12th), it eliminates the risk associated with holding a small group of issues. Second, the fund trades on the NYSE, offering ample liquidity. The fund can be bought or sold at any time the market is open.
Another huge bonus of this fund is that it pays distributions every single month (unlike individual bonds, which typically pay interest twice per year). The last distribution was $0.44 per share, and the past year’s distributions have totaled $5.53 per share for a solid trailing yield of about 5%.
LQD’s average overall credit rating is “BBB+,” two steps above “junk” status. Its largest sector holdings are banks, telecom, and oil and gas producers. Top holdings include the debt of well-known names like Verizon (NYSE: VZ), Wells Fargo (NYSE: WFC), and Walmart (NYSE: WMT).
The performance of LQD has endeared it to investors as a safe-haven investment. In the past three years, while the S&P 500 has returned -9.9% annually, the fund has posted an average annual total return of +7.0%. In fact, LQD actually had positive total returns in 2008 — during the bulk of the market crash. And most recently, while the S&P 500 fell sharply between late April and early July, LQD actually increased in price as investors flooded to its safety.
While the performance has been great, bonds still have a glaring vulnerability… interest rates. As rates rise, bond prices fall. So far, the Federal Reserve has kept interest rates at rock-bottom levels in order to stimulate the economy. That means rates have just about nowhere to go but up. Many contend that the Fed may have to raise rates significantly in the future in order to fight inflationary pressures created by skyrocketing debt and deficits.
To combat this, LQD has relatively short-term exposure — more than 70% of the portfolio matures in less than ten years (26% in less than five years). This makes the fund less vulnerable to rising interest rates than longer-term funds since it can reinvest the funds from maturing bonds into newer issues with higher rates.
Rising rates, however, might be still be well into the future as the recovery appears to be sputtering. Housing starts, a key leading indicator, fell -10% in May (a five-month low) and private sector job creation continues to be below the amount needed just to hire new workers entering the workforce. In fact, just last month the Commerce Department lowered its first quarter U.S. GDP growth forecast to +2.7% from a previous +3%. In the face of these results, the Fed continues to say it will hold rates low for “an extended period.”
Action to Take –> Risk-averse investors can buy LQD here as it should continue to provide a relatively secure investment that pays a solid yield. While the price is near a 52-week high, its quality portfolio and plenty of nervous investors should support the fund price for the foreseeable future.