QLTA - QLTA: When Quality Is Too Much Of A Good Thing

2023-08-24 04:06:32 ET

Summary

• The iShares Aaa - A Rated Corporate Bond ETF tracks highly rated corporate bond securities issued by US and non-US corporations.
• Despite its high-quality portfolio, QLTA has delivered modest returns, ranking fourth quartile against the Morningstar Corporate Bond category.
• This is because the QLTA gives up 65-70 bps in yield for a nominal improvement in credit quality.
• I would personally avoid the QLTA ETF and seek to obtain high quality yields elsewhere.

The iShares Aaa - A Rated Corporate Bond ETF ( QLTA ) focuses on the highest quality corporate bonds. Although the QLTA ETF focuses on high quality credits, it is still susceptible to losses from duration. In fact, my analysis suggest QLTA's myopic focus on Aaa to A-rated securities reduces the portfolio's yield without a commensurate reduction in credit defaults, leading to long-term underperformance. I would avoid the QLTA ETF.

Fund Overview

The iShares Aaa - A Rated Corporate Bond ETF tracks the performance of fixed rate U.S. dollar-denominated bonds rated-Aaa to Single-A, the most highly rated corporate bond securities issued by U.S. and non-U.S. corporations.

The QLTA ETF has $926 million in assets and charges a 0.15% expense ratio.

Portfolio Holdings

Figure 1 shows an overview of QLTA's portfolio. The fund holds almost 2,800 securities with an overall effective duration of 6.9 years and 5.6% yield to maturity.

As the description of the fund suggests, the QLTA ETF holds the most highly rated investment grade ("IG") fixed income securities with 2.3% of QLTA's portfolio rated AAA, 14.3% rated AA, and 82.2% rated single-A (Figure 2).

QLTA's sector allocation is shown in Figure 3. 36.5% of the portfolio is in the Banking Sector, 14.3% is in Consumer Non-Cyclical, 11.2% is in Technology.

Returns

Figure 4 shows the historical returns of the QLTA ETF. Despite the high 'quality' nature of QLTA's portfolio, the QLTA ETF has only delivered modest returns, with 3/5/10Yr average annual returns of -5.0%/1.2%/2.1% respectively to July 31, 2023.

In fact, looking at the quartile ranking of the QLTA ETF, it is fourth quartile ranked on all time-frames against peers in the Morningstar Corporate Bond category.

For example, a similar investment grade credit fund, the iShares iBoxx $ Investment Grade Corporate Bond ETF ( LQD ), has returned 1.7% and 2.7% on 5 and 10Yr time frames, significantly ahead of QLTA's 1.2% and 2.1% (Figure 5).

What could be the difference between QLTA and LQD's performance? The answer may be QLTA's myopic focus on the highest credit quality securities as the LQD ETF has a large allocation to BBB-rated securities (Figure 6).

Historically, defaults are very rare for investment grade bonds, with default rate for even BBB-rated (the lowest investment grade rating) securities being only 0.15%, on a 1-year time horizon (Figure 7). Credit defaults typically need time, and/or the issuer needs to fall out of investment grade rating, before we see a pickup in defaults.

However, for the QLTA ETF, in exchange for obtaining a slightly higher portfolio credit quality, the QLTA may be giving up 65-70 bps in average yield. For example, Figure 8 shows the 10 year average spread of Single-A rated securities is 1.03%, while the 10Yr average spread of BBB-rated securities is 1.70%, as shown in Figure 9.

In effect, the QLTA ETF is too careful in its credit quality allocation and may be giving away too much yield in exchange for a nominal improvement in credit quality.

Distribution & Yield

The QLTA ETF is currently paying a trailing 12 month distribution yield of $1.48 / share or 3.2% (Figure 10).

Investors should note that QLTA's distribution has been on a rising trend, with the most recent monthly distribution of $0.1428 annualizing to a 3.7% yield.

However, for conservative income-oriented investors, I would not recommend the QLTA ETF for 2 reasons. First, although the QLTA ETF has minimized credit risk with its focus on Aaa - A rated securities, the ETF is still susceptible to duration risk. The QLTA ETF, with its 6.9 years effective duration, will decline by 6.9% if interest rates increase by 1.0%, on a first order approximation.

In 2022, the 7Yr treasury yield increased from 1.44% to 3.96% or an increase of 2.52% (Figure 11). When applied against QLTA's 6.9 year effective duration, we can see that duration explained 17.4% of QLTA's -15.3% total return, with portfolio yield offering a small offset.

Second, with risk-free 3 and 6 month treasury bills currently yielding close to 5.5%, it may not make sense to accept QLTA's credit risk, however remote (Figure 12).

Conservative income-oriented investors, if they truly want to lock in today's elevated yields, should look to buy term funds like the Invesco BulletShares 2026 High Yield Corporate Bond ETF ( BSJQ ) that hold investments that mature at a given date, or individual high quality bonds that match their investment horizon.

For example, if an investor has a 2 year investment horizon, say she is saving to buy a house in 2 years, she can invest in a 2 year treasury bond at 4.97% yield. Irrespective of where interest rates go in the intervening 2 years, the investment in a 2 year treasury bond today will be redeemed at par in 2 years' time and the investor will earn a 4.97% per annum total return.

On the other hand, an investment in a bond fund like the QLTA ETF, which tends to maintain a fixed duration, will have a fluctuating NAV and market price depending on the level of interest rates. If long-term interest rates continue to rise, the market value of the investment may decline, and total returns achieved may be lower than expected (conversely, if interest rates were to decline, total returns may be higher).

Conclusion

Although the QLTA ETF invests in the highest quality corporate bonds rated Aaa to A, QLTA's myopic focus on credit quality may actually be detrimental to total returns in the long run.

Historically, credit defaults in investment grade securities are very low and the trade-off between Single-A and BBB-rated credit quality may not be worth the difference in yields.

Furthermore, although the QLTA ETF has minimized credit risk, it is still susceptible to interest rate duration risk. In 2022, the QLTA ETF lost 15.3%, mostly due to a rise in interest rates.

If investors truly want to lock in today's elevated interest rates, they should consider term funds and individual high quality bonds. I would personally avoid the QLTA ETF.

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