3 Worrying Signs About Corporate Bond ETFs

 In Bond Investing

corporate bond etfs

If you’re a regular reader of my blog, you know I’m not fond of ETF bond funds.

However, I also believe they’ve become far more dangerous as of late.

Below, I’m going to explain why the market for corporate bond ETFs actually signals some pretty troubling developments in the global economy.

It’s for this reason that, even if you don’t invest in them, they could soon affect your future in a big way.

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US Corporate Bond Market Is the Only Game in Town

Usually, being the only game in town is considered a good thing. Unfortunately, this isn’t the case when it comes to the US bond market, and it should give every investor plenty of reason to worry.

First of all, it’s worth noting why corporate bond ETFs are seeing a serious shot in the arm as of late. That’s because current interest rates have created an environment where it is harder for savers to see even a small rate of return from government bonds.

This has driven many of them into putting their money behind corporate bond ETFs.

That’s not even the tip of the iceberg, though. The real boost in popularity of corporate bond ETFs has more to do with record asset allocation coming from European funds into corporate bonds on the other side of the pond.

This is important to know about because this influx has been caused by three very worrisome factors:

  • Low credit spread
  • Rising forex hedging costs
  • The Low US corporate bond yields

According to an analysis done by Deutsche Bank, this is causing “the definition of reach-for-yield behavior.” That same study added that “the best days of the global reallocation to U.S. credit may be behind us.”

There are many inferences to be drawn from this analysis, not the least of which is that European and other foreign investors need to take on more risk if they wish to generate any type of yield. In some cases, this requires taking on multiple risks.

If a large enough group of investors does this, the mispricing risk could become a severe problem in a very short period of time.

The Record Growth of Corporate Bond ETFs

As we just touched on, it seems pretty clear that a lot of money is going to transfer from Europe to U.S. corporate bond ETFs. It’s already happening, and I believe more of the same is most likely inevitable.

Now, Blackrock, the world’s largest provider of ETFs, may be plenty happy about this, but that doesn’t mean the rest of us should be. For them, this is a banner year, their best since 2012. Over the past six years, global bond ETFs have actually tripled in size.

Still, I think it’s a mistake to celebrate this “staggering” growth. For one thing – and maybe most importantly – the liquidity of the underlying bond market is far from certain. We’ll cover that in more detail in just a moment.

The main thing I want to address here is that the parabolic rise we’re seeing in ETFs looks very bubbly. In other words, what goes up must come down, and I believe there’s a good chance we’re on the eve of the latter part of that equation.

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The Mirage of Liquidity

Liquidity is something most investors don’t understand. Sadly, this even includes many who should because it’s their job to. The fact of the matter, though, is that liquidity often seems like such a basic principle that even the pros overlook it when staring at the horizon.

I’ve talked about the dangers of liquidity before and mentioned how it’s largely in the eye of the beholder.

This is a great example of this point, though. The rush for yields that we’ve covered so far is going to cause liquidity to dry up quickly. Basically, you’re going to have a lot of people who want to sell their corporate bond ETFs and no one who is willing to buy them.

Furthermore, those corporate bond ETFs are holding large quantities of bonds that simply can’t be priced. That’s not going to inspire any liquidity either. Once again, there just aren’t any buyers out there for that product.

Look at the chart. Bond dealers hold more than 2% of the corporate bond inventories in 2008; now it is ten time less in relative terms.

corporate bond etfs

Finally, don’t forget that corporate bond ETFs – for all their facades of grandeur – could experience the exact same level of volatility that we see in the stock market. When you look at it that way, they don’t look so promising, do they?

One of my main worries is that people won’t see these investment vehicles for what they are until the next panic. We’re going to have an army of investors who get caught completely unaware about the value of their bonds.

Worse still, as soon as that knowledge sets in, it will be too late. As soon as these bondholders begin looking to sell, liquidity will dry up, and terror will set in.

What to Do About the Stage of Corporate Bond ETFs

Where does this leave you, the typical investor? Well, I’ll always advocate a goal-driven investment approach (more on that in a moment). This changes nothing in that regard. If you’re a boomer nearing retirement, I’d still recommend bonds for your portfolio.

Let’s cover some other points of advice, though:

  • Shorten the duration of your portfolio
  • Hold bonds until maturity
  • Reallocate assets from bond funds – especially corporate bond ETFs – and put them into a laddered portfolio of high-grade individual bonds. This is because individual bond portfolios are immunized from those worrisome rising interest rates and credit spreads but, again, only if you hold them until maturity like I just recommended

I can’t stress this part enough: if you’re a baby boomer, you need to take an asset dedication approach.  This goes for those who have retired and those who are hoping to do so soon.

Corporate bond ETFs are not the fantastic investment vehicle many have made them out to be. When you understand other factors in play, their current moment in the sun is not just easy to explain but terrifying to behold.

Take the investment advice I outlined in the last section and, please, stay away from corporate bond ETFs.
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Sergey Sanko
Sergey had started an IncomeClub after years of being an investment advisor for high affluent investors and managing fixed income securities. He is the lead investment advisor representative and holds a Series 65 license. Sergey earned his Executive MBA degree from Antwerp Management School.
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