Just hours before the U.S. election got underway, investors pulled the most cash ever from the world’s largest exchange-traded fund tracking corporate bonds.
As market volatility awakens and the pandemic hits America Inc.’s creditworthiness, more than $1.4 billion exited the iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD) on Monday, according to data compiled by Bloomberg. Trading activity included a single transaction worth about $250 million, though it’s unclear if that constituted selling or buying.
Given how much LQD has rallied in the months since the Federal Reserve’s credit-market backstop, there would be “solid reasons” to reduce long positions on the eve of the U.S. presidential vote, according to Mizuho International Plc.’s Peter Chatwell. Not only are corporate bonds vulnerable to a selloff should equity markets swoon, but LQD’s relatively high 10-year duration -- a measure of sensitivity to rate changes -- means the fund could suffer if a wave of risk-on sentiment boosts yields, he said.
“Most market focus ahead of the election has been on the downside risks to equities, but credit is almost as vulnerable,” said Chatwell, Mizuho’s head of multi-asset strategy. “Locking in some profit at this point makes plenty of sense.”
All in, the redemption dwarfs the previous record of $1.1 billion in late February when the coronavirus sparked widespread turmoil. Yet even without the election, LQD has been quietly getting more risky as rating downgrades and a boom in issuance take the number of BBB rated securities in the $54.7 billion fund toward a record.
Out of 2,321 holdings, the ETF had 1,150 bonds rated BBB at the end of October, data show. The hefty contingent underscores the need for investors to look under the hood of funds they choose, according to Bloomberg Intelligence’s James Seyffart. Rising infection rates and new lockdowns could spell trouble for at least some of these bonds.
“Triple B minus bonds run the risk of being downgraded to high yield and being sold off,” said Seyffart, an ETF analyst. “In an era where we’re looking at more lockdowns and further economic damage, that’s definitely a risk.”
Exposed to Virus
There have been more than twice as many downgrades to American companies this year than in 2019 thanks to the pandemic and the economic damage it has inflicted. That has fanned fears about a potential deluge of so-called fallen angels -- companies that have lost their investment-grade status.
At the same time, lower-rated companies have been loading up on inexpensive debt after rates were slashed to combat the economic fallout of the pandemic.
Almost 5% of LQD is weighted to oil and gas companies, 3.5% to retail business, and 3.4% to pipelines. Those are among the sectors that could be hit hardest amid measures to combat a second wave of the virus, according to Wells Fargo Investment’s Sameer Samana.
“We would caution folks on the leisure/travel areas, along with energy and weaker industrials/real estate companies,” said Samana, the firm’s senior global market strategist. “Those worries are not discounted in markets, not fully. Stimulus and the Fed have kept credit markets eternally hopeful and we’re finally starting to see some cracks in that narrative.”
BBBackstop
Still, Monday’s outflow was small compared to the billions of dollars poured into LQD since the Fed announced it would buy credit ETFs to help stabilize markets amid the coronavirus turmoil.
While central bank buying has slowed in recent months, the widespread expectation is that it would ramp up purchases again if more turmoil hits. Both investment-grade and high-yield spreads to Treasuries have tightened dramatically as a result, but have yet to break through their pre-pandemic levels.
Meanwhile, companies have a strong motivation to maintain their investment-grade status, even at the lowest tier, and will trim their leverage levels if necessary, reckons Academy Securities’ Peter Tchir.
“Most will work hard to retain BBB because it means access to unfunded revolvers, commercial paper, etc. These companies have a lot of levers they can pull,” said Tchir, head of macro strategy. “Companies can go back on the ‘debt diet’ if they need it.”
‘Be Diligent’
All the same, evidence of nervousness was growing even before Monday’s record flow.
Investors pulled nearly $500 million from LQD on a single day last week, which was then its biggest one-day withdrawal in a month. In the junk bond space, the $23.7 billion iShares iBoxx High Yield Corporate Bond ETF (HYG) posted a $3.7 billion exodus in its worst week of outflows since late February.
Regardless of the Fed’s support, bonds lower down the investment-grade scale risk undercutting the performance of credit portfolios, according to strategists at Citigroup Inc. Even BBB bonds that have not yet moved into the BBB- bucket tend to underperform during economic downturns and have a much narrower demand base from quality-conscious investors, they wrote last month.
“IG portfolio managers should be especially diligent in vetting bonds seen as ‘solid BBBs’ during recessionary environments,” wrote Daniel Sorid and James Keefe. “At the first sign of weakness, they can widen along the steepest portion of the IG credit quality spread curve into low BBB.”
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