Investment-Grade Bond ETFs may regain appeal

Transportation, energy, food, and other everyday costs have skyrocketed as inflation reached a 40-year high. In an attempt to manage this situation, central banks across the globe significantly increased interest rates from historically low levels. The latest shot fired was a three-quarter of a percentage point increase in the Fed’s benchmark rate announced two weeks ago and will no doubt have a considerable impact on retirees' portfolios, as with all portfolios with fixed income holdings, due to the inverse relationship between rates and bonds’ prices. That is, when interest rates rise, bonds’ yields increase, and their prices consequently decrease. Of course, the opposite holds true in that decreasing rates correspond to decreasing yields and increasing bond prices. 

Bonds and rate hikes: an inverse relationship 

Let us consider a hypothetical scenario where we own a 5-year USD$100 bond paying 3% yearly coupons. When the central bank’s chair announced three-quarters of a percentage point rate increase two weeks ago, our hypothetical bond’s coupon remained and continued to pay 3%; its yield increased to a hypothetical 3.5%, and its price decreased to some USD$95. 

Our bond traded at a discount following the central bank’s rate hike. This was partly attributed to the fact that newer bonds may be issued with a coupon higher than 3.5%. This makes our bond less attractive unless we find someone willing to hold it by paying a lower price. Another problem is investors eschewing the current bond for higher-paying ones. The heavy selling puts downward pressure on the bond’s price and causes prices to slide.

Now that Treasury yields have shot higher, bond prices have dropped accordingly. The Federal Reserve and other central banks have embarked on the path of rate tightening and liquidity normalization. The yields that investors expect to gain from debt products are increasing, making higher-quality bonds such as government bonds and investment-grade bonds slightly more attractive to investors. 

Bond credit ratings

Standard & Poor’s, Moody’s, and Fitch are the three main rating agencies that evaluate a bond’s creditworthiness based on the issuer's financial ability to make interest payments and repay the loan in full at maturity. According to Standard & Poor’s and Fitch, an investment-grade bond is any bond having a credit rating BBB and above (BBB, A, AA, and AAA included). Similarly, any rating above Baa (Baa, Aaa, Aa, and A included) is considered, by Moody’s, an investment grade. 

Conversely, high yield bonds have ratings below BBB (by Standard & Poor’s and Fitch) and Baa (by Moody’s). They are known for their higher probability of default compared to investment-grade bonds. 

What are investment-grade bonds?  

The fixed income space is generally split into two main categories, investment and non-investment grade bonds, with investment-grade bonds generally associated with being of higher quality.  An investment-grade credit rating indicates a lower risk of credit default and a higher capacity to repay loans, making investment-grade bonds the go-to choice for conservative investors. Yields for investment-grade bonds are typically lower than those of their high-yield counterparts. 

Investment-Grade Bond ETFs you can invest in

After years of loose monetary policy in the United States, the Fed began raising its overnight lending rate in March. The latest three-quarters of a percentage point hike couple of weeks ago was the biggest in almost 24 years. 

On the other side of the Atlantic, economists and analysts agree that a rate hike is taking place soon, but they differ on the size and magnitude of such an increase. Investment-grade bonds ETFs offer a safe haven for conservative investors with a long-time horizon.

The iShares Core € Corp Bond UCITS ETF (IEAC)[1] and the iShares $ Treasury Bond 3-7yr UCITS ETF (CSBGU7)[2] are the two largest Europe-listed corporate and government Investment-Grade Bond ETFs, respectively. Assets under management reached USD$8.08 billion for IEAC and USD$4.21 billion for CSBGU7. Both ETFs are passively managed:  IEAC aims to track the Bloomberg Euro Aggregate Corporate Total Return Index, while CSBGU7 seeks to track the performance of the ICE U.S. Treasury 3-7 Year Bond Index. The former ETF invests in a portfolio of investment-grade, euro-denominated, fixed-rate securities. The 3,464 holdings are spread across 12 different sectors, such as 29.89% in Banking, 14.53% in Consumer Non-Cyclical, 8.69% in Consumer Cyclical, and many others. IEACis globally diversified, holding 20.53% of its assets in France, 18.85% in the United States, 14.28% in Germany, and nine other countries. Meanwhile, CSBGU7 provides direct investments in government bonds with targeted exposure to medium-term US treasuries. Thus, the fund is geographically concentrated in the United States. Both ETFs have almost the same effective duration, 4.56 years for IEAC, and 4.80 years for CSBGU7. Similarly, both funds share almost the same average coupon, with IEAC having an average coupon of 1.44%, costing 0.2% a year to own, whereas CSBGU7 boasts an average coupon of 1.58% while costing 0.07%.

More Fixed Income ETFs on our screener

The Trackinsight Fixed Income ETF Screener identifies 726 Investment-Grade Bond ETFs that are currently listed and trading in Europe. Together they manage USD$258 billion[3] of assets while attracting CAD$19 billion of investors’ money year-to-date.

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[1]  IEAC - Fund data as of June 28th, 2022.

[2] XBB - Fund data as of June 27th, 2022.

[3] AUM and fund flow data as of June 24th, 2022.