The iShares 0-5 Year Investment Grade Corporate Bond ETF (NASDAQ:SLQD) tracks bonds with some low degree of credit risk from the US corporate sector. There is some duration risk here, as well as some corporate credit risk. We think markets are discounting the risks of higher rates, as well as the fact that there are quite a lot of bonds in the corporate sector that may become subject to higher risk premia. SLQD is not an especially safe option.
Credit ratings are mostly A and BBB rated. Definitely investment grade, but not US Treasuries – even though those have been downgraded, although with pretty little market impact. Duration is a little over 2 years, so there’s a fair bit of sensitivity to changes in rates over that horizon. Average YTM is around 5.6%, which means about a 0.7% risk premium for the average A-BBB rating across the portfolio.
Here are the concerns with the current pricing of SLQD. The first thing is to do with the general rate environment. We are seeing some oil inflation, which is going to be a problem for inflation expectations. Stripped figures like core inflation are nonsensical, especially in the US, where people’s disposable income and inflation expectations are of course going to be affected by a commodity that governs an American’s mobility, in addition to all industry which is going to be energy intensive. Anything that risks raising inflation expectations is going to be met by the Fed with higher rates, which is bad for SLQD which still has 2 years of duration and sensitivity to higher rates.
The additional problem is that general inflationary pressure from the supply side is not over as the Ukraine war is still impacting supply chains, as well as the renewed trade wars with China. Moreover, the US is continuing with fiscal looseness which was the cause of the recent US Treasury downgrade and is going to make it essentially impossible for inflation figures to fall rapidly to the 2% target now that all the base effects and easy wins are over.
Finally, SLQD will have to deal with the fact that risk premiums are historically low. While credit risk is low in SLQD, the fact that there is a maturity wall coming in 2024 and costs of capital are materially higher now will inevitably affect the general situation with liability management in the corporate sector. Credit premiums are likely to rise and hit bond values.
The mitigating factors are that we are seeing deflation in China, an important wallet. This could reduce global inflation further on the commodity side and ease the US inflation situation. Moreover, it signals that there may be more downside in terms of spending for the US economy from the current rate regime – that the rate hikes will have lagged effects, which is Macro 101. The next shoe to drop could be rents, and that is a reasonable argument to make at this point in time and will help the US inflation situation. However, with the fiscal excesses, this may not be enough. Moreover, expectations could become embedded before the impact of lower Chinese demand transmits into the US and Western markets, which are less proximal than other markets like Japan. Also, even if inflation does indeed calm down, the China situation could be foreshadowing global deflation, which would be a lot worse than inflation. In fact, US inflation figures, if calculated the same way Europe calculates them, in particular around rents, would be much closer to the 2% policy rate than it stands currently. The inflation case is not shut yet, so fixed income is likely to see some more downside surprises. At least SLQD isn’t an ultra-long duration play, where the tail end of the yield curve could still see some more revision due to structural factors like deglobalisation. Also, the aggregate demand situation is not certain either, where there is the potential of deflation too. Achieving a soft landing is historically not likely after quite meaningful shocks as we’ve seen in the current environment, but anything is possible.
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