While Treasury and government bond ETFs are often used by investors to hedge a bet on equities, corporate bond ETFs are another, riskier option to increase yield while hedging an equity bet. While corporate bond ETFs usually offer a higher yield, they also offer greater risk. They also incur a greater tax burden than many government bonds (which are tax free), and they have provisions which make them less reliable than government bonds as a source of steady income. Still, they are a popular option for investors looking for a lower-risk way to earn a consistently higher yield, if they expect a drop in stock value and/or greater volatility in equities.
Introduction to Corporate Bonds
Like government bonds, corporate bonds are a form of debt that is issued by a company. Usually, corporate bonds are issued in blocks of $1,000 per bond, and pay a standard coupon over the period of the bond, which varies from short-term to long-term. Most corporate bonds last longer than one year.
Because companies are considered higher risk than governments, corporate bonds almost always offer a higher yield than government bonds. There is a chance that companies will go bankrupt and fail to pay back their debts, including their corporate bonds.
In other situations, companies will sometimes pay back their bonds early (almost all corporate bonds have provisions for early payment), which is not commonly done with government bonds. This makes corporate bonds less predictable as a debt instrument. However, since corporate bonds have a fixed rate and a fixed period for payment, they are often considered a lower-volatility option to equity ownership. Corporate bonds are rarely defaulted on (although more frequently than municipal and federal debt), making them an attractive form of lower risk steady income to investors.
Corporate bonds will tend to rise in demand during deflationary periods when companies retain healthy balance sheets. This is because companies have enough cash to pay their debts, but a lack of inflation means their inherent values and earnings might not rise enough to warrant an equity play. Like government bonds, corporate bonds are one way to hedge against deflation, and are usually part of a well-diversified portfolio.
Corporate Bond ETFs
Because corporate bonds are one of many investment vehicles that investors need to consider when managing their portfolios but the corporate bond market has a high barrier of entry, there exist several corporate bond ETFs that investors can choose to enter the corporate debt market. For investors looking to hedge equity holdings, to augment a portfolio with fixed income, or looking to diversify to minimize market exposure, corporate bond ETFs are an attractive option.
So attractive, that corporate bond ETFs saw meteoric increases in volume and value after the subprime mortgage crisis in 2008. As investors grew scared of company profitability and the economy as a whole, they flocked from equities to debt. While most of the money flowed to government debt, some more aggressive speculators went into corporate debt as a high yield government debt alternative. The result was rising values of corporate bond ETFs.
There are several corporate bond ETFs, but here are the three most popular:
- The SPDR Lehman High Yield Bond ETF (JNK): Unfortunately named for an investment instrument released in 2007, the Lehman fund has diversified holdings in high yield corporate bonds in an attempt to track the corporate bond market as a whole. The fund has a monthly dividend payment, and a yield of around 7%.
- The iShares iBoxx US Dollar Investment Grade Corporate Bond Fund (LQD): Another recent strong performer, this is one of the largest by market cap and average volume in the corporate debt category. While the dividend yield is much lower, this reflect the lower risk bonds that the fund invests in. The fund limits itself to American-issued bonds and usually lends to large-cap companies.
- The iShares iBoxx US Dollar High Yield Corporate Bond Fund (HYG): This fund attempts to achieve a higher yield on bonds (as of October 9th, the dividend yield was around 6%) by lending to a wider range of companies while carefully assessing their risk.
Fixed Income, Convexity, and Volatility
Beyond the straight yield offered by these funds, they also offer investors indirect exposure to interest rates, since these will determine the rate at which companies borrow at, since that rate is usually higher than government bond rates.
To understand this in more detail, investors will often calculate the duration and convexity of a bond. They will do this by first calculating the weighted average of how often the principal payment is made by a bond—which is often done using Macaulay’s duration formula.
While most portfolio managers will not actually calculate this formula for every bond in every fund—especially if they are only using bonds to supplement a larger equity play—it is important to be aware of how changes in the duration of a bond will impact its demand in the bond market as a whole. Additionally, portfolio managers will need to understand how the convexity of bonds is changing in addition to their duration.
Convexity measures how steeply a bond’s price is changing in relation to interest rates—in other words, how sensitive is the bond to changes in interest rates. While this measurement is crucial in determining the relationship between long-term and short-term Treasuries, it is also an important determinant in understanding how corporate bond yields are going to rise or fall.
Again, portfolio managers will not usually calculate the convexity of the bonds in their portfolio, especially equity-focused managers. But they need to be aware of how their bond holdings expose them to interest rate changes. This goes for corporate bonds as well as government bonds.