IGSB - IGSB: Salient Risk-Return Metrics Are Starting To Align (Rating Upgrade)

2023-06-23 13:43:44 ET

Summary

• Lower CDS values and a more transparent interest rate cycle outlook lend the iShares 1-5 Year Investment Grade Corporate Bond ETF the necessary latitude to outperform expectations.
• The ETF's exposure to cyclical sectors and high-risk credit can be advantageous if key bond market metrics resume their trajectory.
• In our view, the Fed's pivot will be delayed. Nevertheless, inflation stability provides much to cheer about for corporate bond investors.
• The iShares 1-5 Year Investment Grade Corporate Bond ETF is suitable for those seeking to taxi their capital through trying economic times.
• Risks such as investors "rolling down the yield curve" exist. However, with all factors considered, we are bullish on the ETF's prospects.

The bond market has been a prominent topic of discussion since the turn of the year as fears of a banking crisis and interest rate uncertainty paved the way for much speculation. However, with plenty of aspects being more apparent than they were a few months ago, we decided to update our outlook on the iShares 1-5 Year Investment Grade Corporate Bond ETF ( IGSB ) because of our belief that numerous opportunities exist within the U.S. corporate bond arena.

Let's traverse into a deeper discussion about the iShares 1-5 Year Investment Grade Corporate Bond ETF.

Risk Premiums Are Looking Better

Since our latest coverage , CDS values have retreated significantly, providing much reason for bonds to reach higher valuations. Nonetheless, this exchange-traded fund, or ETF, traded flat during the period, lending us the opportunity to argue that the enhanced credit risk within the bond market is yet to be priced by IGSB's investors.

A primary reason why lower CDS values are alluring pertains to this ETF's allocation. As displayed in Figure 1, the ETF has a lot of exposure to BBB Rated Bonds, which might outperform higher-rated bonds such as AAAs if CDS rates remain low. Moreover, the interest rate environment in the U.S. is much more stable than it was when we last covered this asset, meaning inflation-based risk premiums are probably set to diminish, providing latitude to higher-risk bonds to outperform their counterparts.

Figure 2 conveys the ETF's sector exposure, which coalesces with our credit rating argument. Similar to the aforementioned, we argue that inflation stability and lower CDS rates can provide support to cyclical sectors.

A bird's eye view of the ETF suggests that most of its exposure is within the banking industry, and although it hosts exposure to "consumer non-cyclical," additional weights in sectors like energy, technology, and insurance indicates that this is currently a pro-cyclical ETF.

To end this section, I would like to elaborate on the interest rate environment and what that means for risky corporate bonds.

As recently mentioned by the Federal Reserve , there's a likelihood for moderate interest rate hikes in late 2023 and a pivot in 2024. In our view, core inflation is still very high, illustrating robust consumer power, which will likely see the Fed's pivot date stretched out. However, the good news is that inflation has stabilized and is significantly less volatility than it used to be.

Why is the aforementioned good news? It's good news because inflation uncertainty is a prominent risk factor for corporate bonds, and "assurance" of a pivot in early 2024 could see investors start pricing lower interest rates, leading to higher bond valuations. In essence, broad-based risk premiums are softening, in our view.

Return Prospects

The iShares 1-5 Year Investment Grade Corporate Bond ETF has historically provided investors with a dividend yield ranging from 1.02% to 2.87% . Moreover, the ETF has secured total returns much lower than the S&P 500 (SP500) in the past decade; however, it achieved its returns at subdued volatility.

In a nutshell, the iShares 1-5 Year Investment Grade Corporate Bond ETF is a low-risk investment with moderate return prospects. It is not a speculative asset; instead, it is built for those seeking to "taxi" a portion of their capital.

Critical Risk – Investors Might Roll Up The Curve

Besides the possibility that our outlook on CDS values and inflation might be wrong, an additional risk exists for those interested in this ETF. As shown in Figure 5, longer-term bond yields have recently experienced significant progress, lending investors the opportunity to divest from the short end and invest in longer-term bonds.

Why do I make this claim? Because bond portfolio managers often "roll down the curve " when longer-term yields start rising. They do this by buying longer-term bonds with higher yields and actively selling them a few periods later to reinvest in newly issued long-dated bonds.

There is still a long way to go for today's curve before rolling down is a lucrative strategy. Nevertheless, the trajectory has been initiated, which could result in headwinds for this short-dated corporate bond ETF.

Final Word

Our analysis indicates that the iShares 1-5 Year Investment Grade Corporate Bond ETF is in better shape than it was since our previous coverage due to lowered credit risk and inflation stability. More importantly, the vehicle's recent returns suggest such factors are yet to be priced by investors.

We hereby update our IGSB rating to a Buy.

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