HYG - CORP: Playing It Safe Could Be Costing Corporate Bond Investors

2023-11-10 08:00:00 ET

Summary

• I review the PIMCO Investment Grade Corporate Bond Index ETF and compare it to the HYG ETF and FALN ETF, which invest in lower-rated corporate bonds.
• The article analyzes the risk and return of each ETF, highlighting the differences in ratings, yields, and portfolio strategies.
• Based on that analysis, my view is CORP is only for very conservative investors as the return lost is not justified by the risk avoided. At best, a Hold rating.

Introduction

Based on the accepted investment principle that return should be closely correlated to risk, my article title can be understandable. Within the corporate bond investment world, bonds are commonly divided into investment or non-investment grade segments. One would expect that ETFs that hold the first group to have both lower returns and less risk than ETFs that hold the second. I examined that notion later in this article.

This article reviews the PIMCO Investment Grade Corporate Bond Index ETF ( CORP ) in depth. Afterwards, I compare this ETF against both the iShares iBoxx $ High Yield Corporate Bond ETF ( HYG ) and the iShares Fallen Angels USD Bond ETF ( FALN ). The last ETF holds corporate bonds which were originally rated investment grade but are no longer. They will be used to test the theory about ratings effecting the risk and return of the ETF.

I am giving the CORP ETF a Hold rating with the view that it is best held only by conservative investors. Based on yield and total return, others should consider holding the FALN ETF.

PIMCO Investment Grade Corporate Bond Index ETF review

Seeking Alpha describes this ETF as:

The PIMCO Investment Grade Corporate Bond Index ETF primarily invests in U.S. dollar denominated investment grade corporate bonds with at least one year remaining term to final maturity. The fund seeks to track the performance of the ICE BofA US Corporate Index . CORP started in 2010.

CORP has $873m in AUM, with PIMCO collecting 23 bps in fees. Investors current earn a 4.35% yield.

Index reviewed

ICE BofA US Corporate Index, which tracks the performance of US dollar denominated investment grade rated corporate debt publicly issued in the US domestic market. To qualify for inclusion in the index, securities must have an investment grade rating (based on an average of Moody's, S&P, and Fitch) and an investment grade rated country of risk (based on an average of Moody's, S&P, and Fitch foreign currency long term sovereign debt ratings). Each security must have greater than 1 year of remaining maturity, a fixed coupon schedule, and a minimum amount outstanding of $250 million. Original issue zero coupon bonds, "global" securities (debt issued simultaneously in the eurobond and US domestic bond markets), 144a securities and pay-in-kind securities, including toggle notes, qualify for inclusion in the Index. Callable perpetual securities qualify provided they are at least one year from the first call date. Fixed-to-floating rate securities also qualify provided they are callable within the fixed rate period and are at least one year from the last call prior to the date the bond transitions from a fixed to a floating rate security. DRD-eligible and defaulted securities are excluded from the Index.

Source: fred

The next chart shows the index yield since 1997.

With the index's current yield only topped during periods of great concern, if the US can get its act together over inflation and deficits, yields should start trending down. While that will hurt the ETF's yield, total return should climb as bond prices are inversely related.

Holdings review

All investment-grade corporate bond ETF don't allocate the same, so the next chart is important. These are S&P ratings.

Notice 1.07% are currently rated below investment-grade, which should be removed at the next rebalancing. Here are all the countries where the market weight allocation tops .5%. In total, there are 36 political entities represented.

Despite 20% of the portfolio being non-US, all bonds are denominated in USD so there is no currency risk. PIMCO provided the top sector exposures but these only account for 45% of the total.

Banks: 18.7%

Electric Utilities: 11.1%

Technology: 7.2%

Brokerages: 4.5%

Pharmaceuticals: 4.3%

Top holdings

CORP holds over 1350 bonds, with the Top 20 equaling just over 9% of the portfolio weight. The biggest corporate weight for an individual bond is only .53%. Data did not make it easy enough to identify the highest exposure by issuer.

The ETF also holds an assortment of other assets. The CDX IGs are tradable credit default swap indices covering North American Investment Grade bonds.

Distribution review

With a reported 17% portfolio turnover, payouts have been able to be increased as incoming bonds had higher coupons than those removed from the index, thus the ETF. Seeking Alpha Quant awarded CORP a "B" rating for this ETF factor.

Comparison analysis

In order to appreciate the differences in risk and returns, I collected data points to help with that analysis.

While at 4X the lowest investment-grade rating class default rate, a fund owning a small amount of BB-rated bonds might be acceptable, but owning B and then CCC and below would drastically increase the rate of the bond not paying off at Par. HYG shows they hold 10% and FALN holds 5% rated single B or lower.

One question investors need to ask is how A-rated and BB-rated yields compare to similar duration UST yields to know whether they are getting "paid" for the added default risk lower rated corporate bonds have. I chose to show the corporate yields and spreads against the UST 10Y data.

Both spreads are still wider than what they were before the FOMC starting rising rates in 2022 but are trending downward. By going from A to BB, investors pick up 144bps in yield, or about a 24% increase on average. BBs are yielding almost 300bps above 10-Yr USTs.

Author's note: With all the data from the same fields, I'm not sure why the gaps above do not match the difference in the charts.

Final thoughts

While each investor needs to decide how much extra yield they need to move down the ratings ladder, looking at these three ETFs, my thoughts are:

• Conservative investors might be willing to own CORP and forego some returns, but I would not. My exposure is with a FALN equivalent ETF.
• Holding prior IGs has proven to better strategy than ETFs that focus on bonds originally rated below IG status. HYG is allowed to hold bonds originally rated IG.
• With the shortest duration, HYG should underperform the other two ETFs when rates start declining, everything else being equal.
• Both HYG and FALN, based on Sharpe and Sortino ratios, have rewarded investors for the added default rates of the bonds they hold compared to CORP, even though they have higher risks.
• If one fears a recession, avoiding HYG with its high allocation to B and lower rated bonds is recommended.

With CORP having the longest duration, it should do well once rates start coming down, but FALN's is close enough to warrant consideration. At where I see rates and the US economy, I would rate CORP only as a Hold with preference to accept the added risk and return that FALN has.

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