IEF - GBF: Don't Miss The Curve Rally Via This Investment Grade Fund

2023-04-14 14:22:04 ET

Summary

• The iShares Government/Credit Bond ETF is composed of Treasuries, Agency MBSs, and Investment Grade corporate bonds, with a 62% allocation to AAA assets.
• The exchange-traded fund has a very similar composition and risk metrics as the much better-known iShares Core U.S. Aggregate Bond ETF.
• Given the current SOFR curve, and the fund's duration, we estimate a 12%+ price return in the next year.
• The iShares Government/Credit Bond ETF has a 30-day SEC yield of 4.16% and a low standard deviation of 6.5% (3-year look back).

Thesis

With the Fed hiking cycle apparently coming to an end, it is time for us to re-visit relatively safe, unleveraged fixed-income instruments that are set to benefit:

The SOFR and LIBOR curves are telling us that Fed Funds are set to peak in June, with a gliding down path afterwards. If we anticipate lower rates, then in the fixed-income world we should be looking at funds that are driven by rates. One of these vehicles is the iShares Government/Credit Bond ETF ( GBF ), which is composed of Treasuries, Agency MBSs, and investment grade corporate bonds.

As per its literature, the fund:

[...] seeks to track the investment results of an index composed of U.S. dollar-denominated government, government-related and investment-grade U.S. corporate bonds.

In this article, we are going to have a look at GBF's composition, its peers, and its historic analytics and expectations for 2024.

Composition and Analytics

Let us have a look at the fund's composition and risk metrics:

GBF is overweight Treasuries and Agency MBS bonds, which on aggregate represent more than 60% of the fund. We are going to go into more detail regarding the collateral in the "Holdings" section, but think of GBF as a 60% Treasuries/MBS and 40% corporate credits type of fund.

We can see from the above table that, from a composition perspective, the iShares Core U.S. Aggregate Bond ETF ( AGG ) is the one closest in terms of holdings. The two vehicles also have very similar duration and volatility profiles (as seen in their standard deviations).

Conversely, the iShares 7-10 Year Treasury Bond ETF ( IEF ) is composed solely of Treasuries, while iShares iBoxx $ Investment Grade Corporate Bond ETF ( LQD ) is a corporate bond fund (investment grade paper). Both IEF and LQD have higher durations as well.

We can see from the table above that during the last monetary easing normalized cycle (we are looking at 2018-2019 here since the Covid one was an aggressive crisis response rather than a normal cycle) GBF gained 9.5% versus 8.4% for AGG. This is explained by the larger corporate allocation for GBF. The highest performer was LQD, with a higher duration and a portfolio entirely composed of corporate bonds.

How Much Will It Make?

If we re-visit the Chatham forward curve for SOFR, we can see that market participants are expecting a rough 200 bps decrease in yields (front end of the curve) from late 2023 to the end of 2024. Let us just extrapolate that and assume the 7-year point in the curve does something similar (i.e., a rough 200 bps shift down). If we subsequently multiply the fund's duration by 2x, we get a rough return estimate of 13% for 2024, plus the yield the fund is going to generate.

There are a couple of assumptions going into this calculation, but it is safe to assume a total return in excess of 12% for this fund once rates peak. Again, this is mostly a pure rates play, and it might get a bit of a backwind from spread compression as well.

Holdings

As detailed above, the majority of this fund sits in Treasuries and Agency MBSs:

The rest of the fund is allocated to corporates, and the graph details the various sectors within that allocation. This is a pure investment grade fund:

AAA assets make up 62% of the vehicle, with the BBB bucket being the second-largest one. As mentioned above, this fund is mostly a rates play.

Performance

The fund benchmarks favorably with AGG on a historic basis, the two vehicles having very similar total returns:

We can see how on a total return basis the funds with longer duration such as IEF and LQD do better, outperforming during the zero rates environment in 2020/2021, but also exposing a deeper drawdown. GBF and AGG have very similar curve returns.

Conclusion

The iShares Government/Credit Bond ETF is a fixed-income exchange-traded fund. The vehicle is composed of Treasuries, Agency MBSs, and Investment Grade corporate bonds, with a 62% allocation to AAA assets. The fund has a very similar allocation and risk metrics as the much better-known iShares Core US Aggregate Bond Fund.

GBF has a 6.5 years duration and is set to benefit as the Fed will eventually lower rates. The fund gained 9.5% in 2019, during the last monetary easing environment. With the current SOFR curve implying a 200 bps easing by the end of 2024, we estimate a price move for GBF in excess of 12%, in addition to the current dividend yield of 4.16%. iShares Government/Credit Bond ETF is an unleveraged take on rate-sensitive assets, and it will represent a nice play on the curve rally that will eventually happen in late 2023.

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