IGLB - IGSB: Rate Cuts Priced In Here Is Where You Can Do Better

2023-12-14 07:00:00 ET

Summary

• November to mid-December has been a great time for the capital markets.
• iShares 1-5 Year Investment Grade Corporate Bond ETF has lagged its brethren in terms of performance, thanks to its low duration.
• We examine the setup and tell you why Treasury Bills may be your best bet relative to the IGSB ETF.

The Fund

Investors looking for exposure to investment grade, USD-denominated corporate bonds, maturing between 1 to 5 years, may find a home for some of their dollars in iShares 1-5 Year Investment Grade Corporate Bond ETF ( IGSB ). This passive fund applies the "representative sampling indexing strategy" to select securities from the index it seeks to track, namely the ICE BofA 1-5 Year US Corporate Index. While the exchange-traded fund, or ETF, may not hold all the index incumbents, the goal is that its portfolio as a whole imbibes the investment and fundamental characteristics of the index. IGSB has the leeway to hold up to 10% of its assets in securities other than the type included in the index, as long as the advisor believes that they will assist in tracking the index. Since no attempt is made to outperform the index, the annual management fees for this fund are a nominal 0.04%.

Since unlike funds, the indices do not have any expenses, the benchmark typically outperforms the ETF tracking it by that amount. Impressively, as of November 30, IGIB was slightly ahead of its benchmark over the 1 year period.

And for the 5 years and longer periods, IGSB's performance is closer to the benchmark than one would expect considering its annual expenses. Since inception, it has trailed its benchmark by 28 basis points, partly due to the fact that the fees were far higher back in the day.

Portfolio

The majority of the index securities are from the financial sector, and thus the top 10 issuers in the IGSB portfolio do not surprise.

The sector composition of the around 3,700 securities portfolio also shows financials forming the overwhelming majority.

As noted in the IGSB prospectus, the ETF aims to maintain a weighted average maturity of 3 years or less. We can see below that more than half of the current portfolio holdings will mature in that timeframe. As a whole, the portfolio has a weighted average maturity of 2.92 years.

In terms of credit quality, virtually all the holdings are investment grade, with around 45% of the portfolio in BBB-rated issuances, just a rung above the junk status. While the average coupon of the portfolio is 3.72%, the yield to maturity, or YTM, is 180 basis points higher at 5.52%.

Based on the most recent monthly distribution (15.12 cents) and current price ($50.75), IGSB yields around 3.6%. The rising distribution trend is a good indication that the fund will yield far closer to its YTM over the next 12 months.

Coming back to the portfolio characteristics, IGSB has an effective duration of 2.57 years. This gives an indication of the extent to which the portfolio value will decline (2.57%) with a corresponding 100 basis points rise in interest rates (and vice versa). We can get an idea of the inverse relationship in action using the 3-year treasury rate (US3Y) as a proxy for the comparable risk-free rates.

Outlook and Verdict

The current market mood is calling for not one, not two, not even three or four, but five rate cuts by the Federal Reserve. The market savants have also zeroed in on the month that they expect these cuts to begin. We think a reacceleration of core inflation measures could quickly reverse this.

Two of IGSB siblings, provide exposure to investment grade corporate bonds, but of longer maturities. iShares 5-10 Year Investment Grade Corporate Bond ETF ( IGIB ) has an effective duration of 6.08 years and an average yield to maturity of 5.49%.

Whereas, iShares 10+ Year Investment Grade Corporate Bond ETF ( IGLB ) gives you an effective duration of 12.69 years and a portfolio level yield to maturity of 5.60%.

So all three have around the same yield to maturity, but the latter two come with a progressively higher duration risk. Investors tend to flock to longer-duration investments when they anticipate rate cuts, but in this case, the multiple rate cuts have already been priced in for IGIB and IGLB.

Now the advantage lies with holding IGSB, as it comes with a lower duration and gives investors a chance to be on the right side of fixed income should the cuts not materialize at the pace envisioned. What we mean is that the other two could give up a lot of these gains. So, amongst IGIB, IGLB, and IGSB, for new purchases, we prefer IGSB. We don't own it at present, as IGIB is the only winner here relatively in this beauty contest. There are lots of individual bonds (see this for example ), with very low duration risk that gives us a better bang for our money. The one linked above also has, in our view, virtually zero credit risk.

Investors who believe that the euphoria on rate cuts has gone too far may actually do best by simply holding 3 month Treasury bills. The yields on those are comparable to IGSB's YTM currently, and the Treasury bills carry zero risk. We rate IGSB a hold and may consider it if we get a combination of widening credit spreads as well as unwinding of the rate cuts pricing.

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