Loading...
Symbols:
Authors:

Corporate Bonds: When Safe Asset Classes Become Risky

by: Brett Steenbarger September 29, 2008 | about stocks: HYG / LQD    
Brett Steenbarger

Brett Steenbarger

About this author:
Become a Contributor Submit an Article
  • Font Size:
  • Print


(click chart to enlarge)

We hear about "credit crisis" and "risk aversion", but I thought I would make those issues much more concrete for readers. This is not some volatile stock or sector, and it's not a bank. This is a chart of LQD, the iShares Investment Grade Corporate Bond Fund. Note that it's not a junk bond ETF; rather, its holdings are considered investment grade. With the current credit crunch, however, there are increasing fears that companies will not be able to sustain interest payments on bonds. This has created a dramatic selloff, in which LQD has lost 20% (!) of its value in the last three weeks. When you consider the individual retirement accounts, pension funds, and other prudent investment accounts tied to what has been a relatively safe asset class, you can appreciate the turmoil that is spreading from Washington and Wall St. to individual households.

And junk bonds? One knowledgeable source is raising the specter of double-digit defaults, given the high leverage of the issuers. The i-Shares High Yield Corporate Bond Fund (HYG) is down over 20% since May, a stunning drop, but lately no worse than the performance of LQD. It appears that investors are running from corporates altogether, dumping the good with the bad.

Related Articles

This article has 12 comments:

  •  
    Sep 29 09:05 PM
    There are a number of high quality corporate bonds (both CDN & US) that offer attractive yields with AAA credit coverage selling well below par. Now an investor is taking on more risk than a government or municipal bond, but as part of a diversified portfolio an income investor can certainly do 150-200 bp's above any government paper if they due their DD appropriately.

    An ETF may still be a viable option for investors not comfortable looking into individual company books, but the diversification amongst a number of companies should protect you over the long-term. During this period of volatility - anything can happen (frown).
    Reply
  •  
    Sep 29 09:16 PM
    lqd: 38.3% banks and financials
    i'll pass
    Reply
  •  
    Sep 30 12:45 AM
    Q: How do you incorporate the risk that the government will 'interfere' in the market for your bonds and reduce their value to zero ala WaMu?

    A: You lower the price and raise the yield.
    Reply
  •  
    Sep 30 12:49 AM
    It is pretty dishonest to say LQD "is not a bank". The only reason it is considered investment grade is that S&P and Moody's ratings are so irresponsible as to be criminal negligence. It is stuffed full of bonds from troubled banks. It hasn't dropped like a rock because "increasing fears that companies will not be able to sustain interest payments on bonds". It has dropped like a rock because people have JUSTIFIABLE concerns about the accuracy of the balance sheets of many of these banks. At this point I have stopped believing anything they say anymore on their balance sheets. It is all lies. They aren't marking to anything. They are letting the bad news out a little bit at a time in the hopes that somehow they won't be caught out in their lies. No one should invest in these bonds until these banks start honestly reporting on the value of their assets. Don't hold your breath though, for a lot of them this isn't an option. If they did, they would be admitting they were bankrupt.

    Reply
  •  
    Sep 30 09:28 AM
    dlr has it dead right. Every other day somebody comes onto SA touting 'value' in this or that bank. Like a broken record, I ask each time what their secret is - how they manage to calculate value on a bank BS (pun intended). Still waiting for an answer.
    Reply
  •  
    Sep 30 12:03 PM
    The problem is that corporate capitalism (including the banking and financial system) is not adequately overseen by us, the American people, through our two legislative bodies in the Congress which have been purchased by corporate money and manipulated by Washington "insiders" and lobbyists.

    Ralph Nader, Dennis Kucinich, Ron Paul and others have been giving us possible solutions for these problems for a long time.

    The present hysteria and comparison of today's financial crisis with 1929 is a simple attempt to suppress a rational discussion of the problems in Congress, a discussion that reflects the opinion and interests of all the people.

    The hysteria promoted by the Bush "Republican" executive branch over the present financial crisis is similar to the hysteria promoted by the executive branch over the Iraq War Resolution and caused it to be rubber stamped by Congress.

    Most of the disasters of the 20th century could have been prevented by a little common sense: World War I and II are among them.

    Why not give reason a chance this time instead of acquiescing to an all powerful executive branch?

    Also, we should remember that the New Deal did not bring back the prosperity of the 1920's but instead preserved America from a socialist revolution by giving the poor just enough bread to prevent it.

    In addition, the New Deal gave Franklin Roosevelt more power than any executive had ever had before him which allowed him to win an unprecedented four presidential terms. If he had lived through his fourth term he would have served for 16 years as president.

    The present "socialistic"... proposals will do the same. They will give the executive branch even more power while persevering the financial system as it is, complete with its massive injustices, inequalities and hypocrisy, and take away the chance for the American people, through Congress, to change the financial system into something more equitable and economically responsive to their needs.
    Reply
  •  
    Sep 30 10:34 PM
    Folks, the only safe asset is gold. That was true last month, last year, and last century. Yes, these bonds are cheap given their relatively strong credit backing. But the chickens of the Fed's ultra-low interest rates are coming home to roost: LQD is yielding less than 6%. That's not a bad return in this market, but it's only 500bp better than cash and not even 200bp better than FDIC-insured CDs. In other words, the yield, such as it is, is not much in absolute terms. And even if one supposes that dollar debasement will cost only the "official" 3-4% per year, it's basically nothing. Under the circumstances, the after-tax, after-debasement real return on these instruments is, charitably, no more than 1%. Anyone else think 1% of those issuers might end up in default in the next year?

    Bottom line: we're not being paid to take the risk at these yields. You want safe, stick with gold. You want to take risks, be sure you're getting paid for doing so.
    Reply
  •  
    Oct 01 01:29 PM
    OldLimey - here is how you value a bank, ignoring the doom-mongering and short term headlines.

    First just look at the total assets line. In normal times, the bank is going to earn 1% on that figure, net of its funding costs and operating expensives. Bloated European banks with high expenses, you can give that a 0.25% haircut. The best run low expense US banks, a 0.25% bonus if you like, or not (that means US Bancorp and Wells Fargo and nobody else, pretty much). Now you know exactly what the bank will earn in the future, after all this passes. Ignore the fact that those earnings will then grow year after year in line with the economy, that is your safety margin. You don't need to pay a dime for it.

    Next you have to figure out how much the current shareholders will own of that future earning stream. The way to do that is to assume the bank will deleverage until its equity capital is a tenth of the liabilities line. Take its current book value, remove all intangibles and goodwill, and any writeoffs already announced since the last sheet, to get a current tangible. The difference between the 1/10th leverage line and the current tangible is the amount the existing shareholders will end up being diluted, more or less. Whether by debt ahead of them, or preferred ahead of them, or net new stock issuance, or asset sales, whatever.

    Now you know what portion of what future earnings you will own as a present shareholder. Put a low cap rate on it, 10 times earnings say. And you are done.

    Will this be right for every bank? No, but it will be about right for the big ones and the others will break randomly around it. It is so conservative for normal times the winners will cover a multitude of sins among the losers.

    Simple, direct, businesslike, and rational. No fear, no doom mongering, no speculation. Everything else is just short term noise, some of which will break for you and some against.

    Now you have your answer. Will you accept it? I doubt it. But it is substantially correct, whether you like it or not.
    Reply
  •  
    Oct 01 11:59 PM
    Gold is not a safe asset.

    Nothing is.
    Reply
  •  
    Oct 02 12:55 AM
    carey_jim, if you don't believe in gold, I can't imagine what you own. A lifetime supply of canned food? It doesn't keep that long. A gun? Me too. It might help me survive someday, but it mightn't be enough. Land? They can take it as surely as the right to short doomed banks. I have absolute faith that my gold will always be worth something. I can't say that about anything else.
    Reply
  •  
    Oct 02 05:36 PM
    I didn't say that owning gold or any other commodity is a bad thing, I'm just reminding you of what you know already: Nothing is certain except death and taxes :)

    Gold might someday be completely regulated by the government as it was in the past. In that sense, it is not safe.

    But safety is a relative thing and one man's mattress is another man's unlocked door.

    You might find it interesting to read William Jennings Bryan's Cross of Gold speech which you can find on the internet.
    Reply
  •  
    Oct 02 07:57 PM
    you guys are both wacko's , LQD will be a good investment for savvy investors buying on the cheap ! Every class of bonds has out-performed gold since it peaked in the 70's at 800 an ounce .
    Reply
More Comments on LQD ยป
More by Brett Steenbarger
Investment Resources
Money Managment
Research
Seeking Alpha provides these ads as a service to its leading contributors
Articles on related themes
Developed Market ETFs
Bonds
Dollar/Currencies
Earnings