LQDH - LQDH: Interest Rate Hedged Investment-Grade Bond ETF With A Solid And Growing 5.4% Yield

2023-06-23 15:15:00 ET

Summary

• LQDH is an interest rate hedged investment-grade corporate bond index ETF with diversified holdings, strong credit ratings, and a good and growing 5.4% yield.
• The fund's use of swaps significantly reduces interest rate risk, resulting in lower losses when rates increase, smaller gains when rates decrease, and a more stable share price.
• An overview of the fund follows.

Author's note: This article was released to CEF/ETF Income Laboratory members on June 3rd.

Most investment-grade bond funds, including the benchmark iShares iBoxx $ Investment Grade Corporate Bond ETF ( LQD ), have significant interest rate risk, with double-digit durations. The iShares Interest Rate Hedged Corporate Bond ETF ( LQDH ), on the other hand, hedges most of its interest rate risk through the use of swaps. The result is significantly lower losses when rates increase, much smaller gains when these decrease, a much more stable share price, and stronger risk-adjusted returns. The fund currently yields 5.4%.

In my opinion, LQDH is a buy, and one particularly appropriate for more conservative income investors wishing to minimize their credit and interest rate risk. As rates are not currently increasing, the fund's interest rate hedge is more of a long-term benefit, but a benefit nonetheless.

LQDH - Overview and Benefits

Diversified Holdings

LQDH is an interest rate hedged investment-grade corporate bond index ETF.

LQDH invests around 95% of its assets in investment-grade corporate bonds. It does so indirectly, through an investment in LQD, the largest, most well-known investment-grade corporate bond ETF on the market, and which functions as an industry benchmark. BlackRock manages both funds. BlackRock waives a portion of its fees for LQDH, resulting in a net expense ratio of 0.24% for the fund, quite low for a niche index fund.

LQD is an incredibly well-diversified fund, with investments in over 2,600 securities from all relevant industry segments.

Diversification reduces risk, volatility, and the magnitude of losses from the default of any individual issuer.

In general terms, LQD's portfolio is reflective of conditions in the investment-grade corporate bond investment universe. LQDH invests in LQD, and so shares these same characteristics.

Strong Credit Ratings

LQD focuses on investment-grade corporate bonds. These are issued by comparatively safe, resilient, credit-worthy institutions, and so sport strong credit ratings. The fund is almost evenly split between bonds rated BBB and A, with smaller investments in higher-rated securities.

Default rates for these securities are generally quite low, even during downturns and recessions. Due to this, these securities tend to perform reasonably well during turbulent times, as was the case in 1Q2020, the onset of the coronavirus pandemic.

LQDH invests in LQD and swaps , the latter of which do not perform all that well during these conditions. But more on that later.

Good, Growing 5.4% Yield

LQDH currently yields 5.4%, a reasonable yield and a bit higher than that of most broad-based bond ETFs, comparable to high-yield bonds.

LQDH's dividends have seen very strong growth since early 2022, courtesy of the Federal Reserve's interest rate hikes.

LQDH's dividends could see some more growth moving forward, due to a delayed impact from recent Fed hikes, and as some recent dividend hikes have yet to be completely reflected in the fund's yield (which considers the last 12 payments).

In most cases, I have some idea of the dividend growth investors can expect from an ETF, using standard yield metrics. These include SEC yields and yield to maturities. For LQDH, I'm unsure of how to account for the fund's use of swaps, so I have very little visibility on its expected dividend growth. A higher yield seems likelier than not, but I'm not confident of this.

Significantly Reduced Interest Rate Risk

LQDH's diversified holdings, strong credit ratings, and growing 5.4% yield are all important benefits, but what really sets the fund apart is its swaps. These derivatives are structured in such a way as to be profitable if interest rates increase, unprofitable if rates decrease. Bonds have the opposite return profile, seeing lower prices (negative profits) when rates increase, higher prices (positive profits) when rates decrease. LQDH's managers buy enough swaps so as to completely eliminate the fund's interest rate risk, in theory at least. In practice, interest rate risk is significantly reduced, but not totally eliminated.

Significantly reduced interest rate risk has three important implications for shareholders.

First, reduced interest rate risk means reduced losses, and hence outperformance, when rates increase, as was the case in 2022. LQDH outperformed most bonds and bond sub-asset classes during the year, including LQD.

As interest rates have stabilized these past few months, reduced interest rate risk is unlikely to provide significant short-term benefits for investors. Still, lower risk is a benefit, and might prove beneficial in the long-run.

The second implication of reduced rate risk, is reduced gains when interest rates decrease. As an example, LQDH significantly underperformed LQD during 2019, during which the Fed slowly, but steadily, decreased rates. At the same time, LQDH did perform quite well on an absolute basis, and relative to some of its peers.

A corollary of the above, is that LQDH tends to underperform LQD during downturns and recessions, as the Fed tends to aggressively cut rates during these. The fact that LQDH's underlying holdings have strong credit ratings has something of an opposite impact, reducing losses during these scenarios. The net effect is unclear, and very dependent on the magnitude of the recession and attendant Fed response.

For reference, LQDH significantly underperformed most bonds and bond sub-asset classes in early 2020, the onset of the coronavirus pandemic.

LQDH could plausibly perform somewhat better during a future recession or downturn, although some underperformance relative to LQD is likely.

The third implication of reduced interest rate risk, is that this serves to significantly reduce overall fund volatility and drawdowns. Exact figures vary, but LQDH is about half as volatile as LQD.

LQDH's greater stability is a significant benefit for shareholders. In my opinion, in the long-run, this benefit makes LQDH a strictly superior investment to LQD. So, for long-term investors looking for comparatively safe, high-quality bond funds, LQDH seems like an appropriate choice.

Why Not T-Bills?

LQDH has many similarities to t-bills and t-bill funds, including the SPDR Bloomberg 1-3 Month T-Bill ETF ( BIL ). Both have very low credit and interest rate risk. Both focus on comparatively low-yielding securities. Nevertheless, both sport reasonably good, growing yields, as the Federal Reserve has hiked rates quite aggressively. Both have broadly similar yields.

T-bill prices are much more stable, however.

Considering the above, t-bills seem like a strictly superior investment to LQDH, but the fund does have one major advantage: its stronger expected performance and performance track-record. Long-term, investment-grade corporate bonds should yield more than t-bills. As such, a long-term investment in LQDH should outperform a comparable long-term investment in t-bills, as has been the case since the fund's inception.

Conclusion

LQDH's diversified holdings, strong credit ratings, solid and growing 5.4% dividend yield, and interest rate hedge, make the fund a buy.

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