Corporate Bond ETFs and Their Underlying Indexes – LQD, HYG, and JNK

Compared to Treasury ETFs, corporate bond ETFs usually offer higher returns to investors. For those with a better tolerance to risks, allocating some of their assets into corporate, high yield bond ETFs is a wise decision. However, there are a lot of different ETFs to choose from this niche space, this article aims to get some deep understanding by comparing two representatives ETFs – iShares iBoxx $ Investment Grade Corporate Bond ETF(LQD) and iShares iBoxx $ High Yield Corporate Bond ETF(HYG).

Firstly, I’d like to juxtapose the two funds’ assets under management(AuM), expense ratio and average spread as follows:

We can see that LQD has attracted more than doubled HYG’s AuM, even both funds were issued by BlackRock, the cost of having LQD is less than one-third of that of HYG.

What really matters is the performance, so let’s take a look at their total return in the past 10-years (chart plot from Chart ETF Returns & Volatility – ETFreplay). The two are highly correlated except during and after the financial crisis. Volatility, however, really differentiated LQD and HYG. To achieve a similar return, LQD investors don’t have to assume as high risk as HYG holders (5.2% opposed to 6.4%).

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Staring at these numbers superficially is not sufficient, we’d better dive deeper to understand how these two funds are formed and managed. To do so, we need to decode the underlying indexes of the two ETFs.

LQD was issued by BlackRock back in July 2002. The average duration is 8.2 years, and there are roughly 1750 holding in the portfolio. HYG was also issued by BlackRock back in April 2007. The average duration is only 3.7 years, and there are about 1027 debt securities. Given the much longer duration of LQD compared to that of HYG, the volatility or risk of LQD usually should be higher than HYG as it would be more susceptible to interest rate fluctuation. So the other facet – credit profile between the two must be significantly different.

LQD’s underlying index is the Markit iBoxx $ Liquid Investment Grade Index. According to the index Fact Sheet, to be eligible in this index, the issuer types are limited to a corporate bond, so Government debt, quasi-sovereign debt, and debt guaranteed or backed by governments are not included. Minimum time to maturity is 3.5 years for new bonds and 3 years for existing index constituents. The outstanding face value of all bonds must be greater than or equal to USD two billion as of the bond selection cut-off dates. Investment grade rating from Fitch Ratings, Moody’s Investor Service, and Standard & Poor’s Rating Services is required. It’s Market capitalization weighted.

LQD, iShares ibex $ Investment Grade Corporate Bond ETF, was issued by BlackRock back in July 2002. The average duration is 8.1 years, and there are roughly 1691 holding in the portfolio. The underlying index is the Markit iBoxx $ Liquid Investment Grade Index.

To be eligible in this index, the issuer types are limited to a corporate bond, so Government debt, quasi-sovereign debt, and debt guaranteed or backed by governments are not included. Minimum time to maturity is 3.5 years for new bonds and 3 years for existing index constituents. The outstanding face value of all bonds must be greater than or equal to USD two billion as of the bond selection cut-off dates. Investment grade rating from Fitch Ratings, Moody’s Investor Service, and Standard & Poor’s Rating Services is required. Its Market capitalization weighted.

 

HYG tracks the Markit iBoxx $ Liquid High Yield Index. Opposed to the Markit iBoxx $ Liquid Investment Grade Index, this index requires a shorter/half time to maturity, 1.5 years for new bonds and 1 years for existing index constituents. In addition, the outstanding amount is lowered from $2 billion to only $400 million. It’s also market cap weighted. Lastly, instead of a requisite investment grade rating, this index only needs the sub-investment grade. As a result, this fund is designed to yield a higher return at the cost of higher volatility too. The name of this index – “high yield”- declares its intention clearly.

HYG, iShares iBoxx $ High Yield Corporate Bond ETF, ranked third with regard to AuM, was also issued by BlackRock back in April 2007. It charges a high fee at 0.5%, but carve out its unique advantage as is the largest and liquid junk bond ETF. It tracks the Markit iBoxx $ Liquid High Yield Index. Opposed to the Markit iBoxx $ Liquid Investment Grade Index, this index requires a shorter/half time to maturity, 1.5 years for new bonds and 1 years for existing index constituents. In addition, the outstanding amount is lowered from $2 billion to only $400 million. Lastly, instead of a requisite investment grade rating, this index only needs the sub-investment grade. As a result, this fund delivers an outstanding performance compared to the rest, 1-year return stands at 11.6% and 5-year return is 6.21%.  Now, let’s compare their historical price performances over the last ten years.

The second biggest ETF in this space is JNK, the SPDR Bloomberg Barclays High Yield Bond ETF, tracking Bloomberg Barclays High Yield Very Liquid Index. is a component of the US Corporate High Yield Index. JNK was issued in November 2007, so far reached an AuM of $11.08 billion.

The US High Yield Index uses the same eligibility criteria that include only the 3 largest bonds from each issuer that have a minimum amount outstanding of USD 500 million and less than five years from issue date. The index also limits the exposure of each issuer to 2% of the total market value and redistributes any excess market value index-wide on a pro rata basis.

Securities must be rated high-yield (Ba1/BB+/BB+ or below) using the middle rating of Moody’s, S&P and Fitch. When a rating from only two agencies is available, the lower is used; when only one agency rates a bond, that rating is used. In cases where explicit bond level ratings may not be available, other sources may be used to classify securities by credit quality.

At least one year until final maturity, regardless of optionality.  Bonds that convert from fixed to floating rate, including fixed-to-float perpetual, will exit the index one year prior to conversion to floating-rate. Fixed-rate perpetual are not included. Sub-indices based on maturity are inclusive of lower bounds. Intermediate maturity bonds include bonds with maturities of 1 to 9.999 years. Long maturity bands include maturities of 10 years or greater. Bonds must have been issued within the past five years. Seniority of Debt Senior and subordinated issues are included. Only taxable issues are eligible.

Dividend Received Deduction (DRD) and Qualified Dividend Income (QDI) eligible securities are excluded.

SEC-registered bonds, bonds exempt from registration at the time of issuance and SEC Rule 144A securities (with or without registration rights) are eligible.  A security with both SEC Regulation-S (Reg-S) and SEC 144A tranches are treated as one security for index purposes. The 144A tranche is used to prevent double-counting and represents the combined amount outstanding of the 144A and Reg-S tranches.

Bloomberg maintains two universes of securities: the Returns (Backward) and the Projected (Forward) Universes. The composition of the Returns Universe is rebalanced at each month-end and represents the fixed set of bonds on which index returns are calculated for the next month. The Projected Universe is a forward-looking projection that changes daily to reflect issues dropping out of and entering the index but is not used for return calculations. On the last business day of the month (the rebalancing date), the composition of the latest Projected Universe becomes the Returns Universe for the following month.

Now the comparison seems to be focused on which yield is better: yield from a long duration or yield from a low investment grade? Looking at the past 10-year performance between LQD and HYG, I think LQD makes a compelling case that it’s better to pursue high yield generated from holding a long period than to bear the risks of investing in “junk” companies. The former yield is less fluatuated than the latter yield. Additionally, LQD’s cost to purchase is much lower than HYG, 0.15% versus 0.49% expense ratio, as is listed in above table.

Lastly, it’s worthwhile to point out that the past 10 years, from 2007 to 2017, is overall a low-interest rate environment, in which, high duration bonds tend to perform better. The future is likely to be burdened by both inflation and deflation factors, so whether LQD can continue beating HYG in terms of return/risk is not a sure thing. We shall always be prudent and thorough when making investment decisions.

Investment grade corporate bond is lucrative and certainly more preferable if investors are able to put money into such corporate bonds in an ETF format so they can reap the profit and simultaneously obtain the risk diversification benefits. There are several such big ETFs as LQD, VSCH, HYG, PFF, and VCIT, and their AuMs are $34.93, $18.94, $18.14, $18.02 and $14.40 billion respectively.

VCSH, Vanguard Short-Term Corporate Bond ETF launched by Vanguard in November 2009 has since accrued $18.94 billion, more than half that of LQD. VSCH’s expense ratio, however, is 0.07%, less than half that of LQD’s 0.15%. It tracks Bloomberg Barclays U.S. 1-5 Year Corporate Bond Index.

It’s also worth mentioning the VanEck Vectors Fallen Angel High Yield Bond ETF – ANGL, aiming to target “fallen angels”—bonds rated investment grade at issuance that has since been downgraded. It was issued relatively recent in April 2012 and has since amassed $ 826.99 million.

The rationale behind this investment is that a downgrade of credit, tends to create a downward pricing pressure, then future credit upgrade will compress credit spread, so the investors attain the price appreciation from this credit vibration.

Not surprisingly, ANGL’s security portfolio has a strong bias to BB-rated bonds, the highest credit rating for junk bonds. It was admonished to trade such kinds of bonds/ETFs with great caution due to thin trading volume and high spread.

Now comparing the performance of these entire three bond ETFs

 

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