Planning your Fixed Income Exit

by Wayne Ferbert on April 3rd, 2013

Check out the  interesting article today in the Wall Street Journal about the Barclays US Aggregate Bond Index. It is the most popular bond index in the US and is used most often as benchmark for many bond funds.  It is an investment grade index.
The article is about how the index has been impacted in this interesting, Fed-fueled market. The key points from the article:
  • Many investors have been selling many of the components of the index: their has been significant outflows from many of the components.
  • The index has significantly increased its Treasury holdings: 37% of the index – up from 21% a decade ago
  • As rates go back up, all fixed income will lose value: in particular, funds that track this index will be hurt disproportionately because of the many short duration low interest rate investments
  • Many institutions are switching indexes: eg, their has been recent demand for custom indexes 
The article points out that this index has averaged annualized returns of 7.68% since 1976 and has had only two negative years in its 37 year history – ’94 and ’99. This compares to the S&P’s average annualized returns of 11.24% over the same period. (Side note: that risk premium of 3.6% doesn’t quite seem worth it when you think about the risk of equities compared to investment grade fixed income.)
These returns and the general stress on the investment grade index has me questioning whether we should get out while the going is still good. We have been using the LQD for our investment grade exposure.
The LQD is the most popular investment grade ETF – which we recommend because it has a very solid options market. Let’s look at the LQD as our proxy for the fixed income market. Note that the LQD is a corporate fixed income vehicle only – meaning no treasuries.
The performance of the last 5 ½ years has been quite a contrast. The LQD, adjusted for dividends, is up 45%. The S&P 500 adjusted for dividends is up only 17% - effectively just the return on the dividends.
While the S&P 500 is just now returning to its November 2007 all-time highs, the fixed income market has delivered not ONLY dividends but tremendous price appreciation (12% increase in the index to be exact). The Fed’s drive to lower interest rates has sent the price of all bonds skyward.
But when do you call the turn? No doubt that it is coming. We recommend thinking about transitioning from LQD in the next 6 months – maybe as your hedges for it expire. The LQD is bound to deliver a negative return year. After all, the dividend is only about 4%. It won’t take much of a turn in interest rates to overwhelm that 4% dividend.
But what do you do with your income seeking investable assets? The High Probability Credit Spread we talk about in this blog is a strong alternative. But we’ll look at some other alternatives in Friday’s post!

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