iShares iBonds investment-grade ETFs - what happens if bonds are downgraded?

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shipbuilder
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iShares iBonds investment-grade ETFs - what happens if bonds are downgraded?

Post by shipbuilder »

I am considering using defined-maturity bond ETFs such as iBonds iShares to set aside money now for some known nominal expenses in future years. These ETFs hold bonds maturing in a particular year and are intended to achieve similar results to holding individual bonds -- if you hold to maturity, you know how much money you'll get in the end -- but with more diversification.

Four flavors of the ETFs are offered, holding Treasuries, munis, investment-grade corporate bonds, and high-yield bonds, respectively. I'm considering using the muni or investment-grade flavor to get a somewhat better yield than Treasuries with relatively little additional risk. (If you're going to hold Treasuries, there doesn't seem to be much point to this kind of ETF anyway, since the individual bonds don't have any credit risk.)

The investment-grade ETFs turn out to hold a lot of BBB-rated bonds. For example, IBDQ, the 2025 ETF, is 53% BBB-rated. BBB is the lowest investment-grade rating, and the prospectus says that if bonds are downgraded below investment-grade, they are removed from the fund's index and the fund rebalances out of them. This made me wonder how I should expect these funds to perform if there are large numbers of downgrades.

If I buy a large collection of BBB bonds and hold to maturity, some may be downgraded and some of those may default, but I will get the expected amount of money from those that don't default. My return will be something like (yield to maturity)*(1-default rate) + (loss given default)*(default rate). Will the ETF behave the same way? It seems possible that downgrades could cause the ETF to underperform a collection of bonds held to maturity because the ETF has to sell when the downgrade occurs and may get a low price at that time (after all, lots of other funds and asset managers will be selling, too). Is that right? If so, can the effect be mitigated by buying a high-yield bond ETF whenever the investment-grade ETF is selling due to downgrades (so that, on net, one is continuing to hold the same set of bonds)?
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Re: iShares iBonds investment-grade ETFs - what happens if bonds are downgraded?

Post by anon_investor »

shipbuilder wrote: Fri Jun 17, 2022 5:58 am I am considering using defined-maturity bond ETFs such as iBonds iShares to set aside money now for some known nominal expenses in future years. These ETFs hold bonds maturing in a particular year and are intended to achieve similar results to holding individual bonds -- if you hold to maturity, you know how much money you'll get in the end -- but with more diversification.

Four flavors of the ETFs are offered, holding Treasuries, munis, investment-grade corporate bonds, and high-yield bonds, respectively. I'm considering using the muni or investment-grade flavor to get a somewhat better yield than Treasuries with relatively little additional risk. (If you're going to hold Treasuries, there doesn't seem to be much point to this kind of ETF anyway, since the individual bonds don't have any credit risk.)

The investment-grade ETFs turn out to hold a lot of BBB-rated bonds. For example, IBDQ, the 2025 ETF, is 53% BBB-rated. BBB is the lowest investment-grade rating, and the prospectus says that if bonds are downgraded below investment-grade, they are removed from the fund's index and the fund rebalances out of them. This made me wonder how I should expect these funds to perform if there are large numbers of downgrades.

If I buy a large collection of BBB bonds and hold to maturity, some may be downgraded and some of those may default, but I will get the expected amount of money from those that don't default. My return will be something like (yield to maturity)*(1-default rate) + (loss given default)*(default rate). Will the ETF behave the same way? It seems possible that downgrades could cause the ETF to underperform a collection of bonds held to maturity because the ETF has to sell when the downgrade occurs and may get a low price at that time (after all, lots of other funds and asset managers will be selling, too). Is that right? If so, can the effect be mitigated by buying a high-yield bond ETF whenever the investment-grade ETF is selling due to downgrades (so that, on net, one is continuing to hold the same set of bonds)?
How much more yield is this product offering over US Treasuries right now?
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Re: iShares iBonds investment-grade ETFs - what happens if bonds are downgraded?

Post by shipbuilder »

anon_investor wrote: Fri Jun 17, 2022 6:24 am How much more yield is this product offering over US Treasuries right now?
About 80 bps over Treasuries, and about 20 bps over munis for investors in the top federal tax bracket. I'm thinking that, for my purposes, the higher yield vs munis isn't worth the added risk. (The muni funds are almost entirely AAA and AA.) Also, marketable Treasuries aren't an option for me for reasons irrelevant to this thread -- I have to get my Treasury exposure through savings bonds or through diversified funds such as Total Bond Market that also hold corporates.
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Re: iShares iBonds investment-grade ETFs - what happens if bonds are downgraded?

Post by anon_investor »

shipbuilder wrote: Fri Jun 17, 2022 8:12 am
anon_investor wrote: Fri Jun 17, 2022 6:24 am How much more yield is this product offering over US Treasuries right now?
About 80 bps over Treasuries, and about 20 bps over munis for investors in the top federal tax bracket. I'm thinking that, for my purposes, the higher yield vs munis isn't worth the added risk. (The muni funds are almost entirely AAA and AA.) Also, marketable Treasuries aren't an option for me for reasons irrelevant to this thread -- I have to get my Treasury exposure through savings bonds or through diversified funds such as Total Bond Market that also hold corporates.
In your situation I would probably just get munis.
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Re: iShares iBonds investment-grade ETFs - what happens if bonds are downgraded?

Post by grabiner »

Whether the funds sell or keep bonds which fall below investment grade, you would expect them to slightly underperform the SEC yield. If a fund sells a bond that is downgraded to junk, it will sell at a loss. If it holds the bond, it may take a larger loss if the bond defaults.
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Re: iShares iBonds investment-grade ETFs - what happens if bonds are downgraded?

Post by alex_686 »

Indexes will kick the downgraded bond out. So this eliminates all pass funds and thus most ETFs.

Every active manager would be more or less obligated to kick the bonds out due to how their prospective reads. There are some edge cases but the impact will be low.
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Re: iShares iBonds investment-grade ETFs - what happens if bonds are downgraded?

Post by grabiner »

alex_686 wrote: Fri Jun 17, 2022 4:15 pm Indexes will kick the downgraded bond out. So this eliminates all pass funds and thus most ETFs.

Every active manager would be more or less obligated to kick the bonds out due to how their prospective reads. There are some edge cases but the impact will be low.
Active funds should have a bit of flexibility. For example,the Vanguard Intermediate-Term Investment Grade prospectus says, "The Fund invests in a variety of high-quality and medium-quality fixed income securities, at least 80% of which will be short- and intermediate-term investment-grade securities." Vanguard's web site says that it holds 3.6% in bonds rated below BBB, and 2.2% not rated (which might include some that are considered investment grade).

But I wouldn't expect funds to deliberately use that flexibility, as they would depart from their stated investment goal. The flexibility allows a fund to hold some bonds which are illiquid as well as having been downgraded to BB.
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Re: iShares iBonds investment-grade ETFs - what happens if bonds are downgraded?

Post by alex_686 »

grabiner wrote: Fri Jun 17, 2022 5:09 pm
alex_686 wrote: Fri Jun 17, 2022 4:15 pm Indexes will kick the downgraded bond out. So this eliminates all pass funds and thus most ETFs.

Every active manager would be more or less obligated to kick the bonds out due to how their prospective reads. There are some edge cases but the impact will be low.
Active funds should have some flexibility. For example,the Vanguard Intermediate-Term Investment Grade prospectus says, "The Fund invests in a variety of high-quality and medium-quality fixed income securities, at least 80% of which will be short- and intermediate-term investment-grade securities." Vanguard's web site says that it holds 3.6% in bonds rated below BBB, and 2.2% not rated (which might include some that are considered investment grade).
Actually this is a excellent example of a fund that does not have flexibility.

You are right, the prospectus is written to give the fund maximum coverage in case shareholders sue. Thus is standard. I have written my fair share of them.

However there is a separate batch of SEC rules covering marketing. Since it has the phase “Investment Grade” it is being marketed as a investment grade fund and thus should only contain investment grade bonds.

There is some flexibility given to operational concerns- in times of volatility with many downgrades and a illiquid market a portfolio manager can be given time for a orderly exit.

However it is not 20% and a manager can’t have junk bonds because they think it is a good value or that a fallen angle will snap back.

If they didn’t have those critical words that in its name you would be correct.
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Re: iShares iBonds investment-grade ETFs - what happens if bonds are downgraded?

Post by Hebell »

Like you, I hold these defined maturity etfs. And I am assuming they will stick with investment grade corporates. I have no interest in the junk fund or the munis. Thus far it has worked very well.
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Re: iShares iBonds investment-grade ETFs - what happens if bonds are downgraded?

Post by Hebell »

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Re: iShares iBonds investment-grade ETFs - what happens if bonds are downgraded?

Post by mega317 »

Hebell wrote: Fri Jun 17, 2022 6:34 pm Like you, I hold these defined maturity etfs. And I am assuming they will stick with investment grade corporates. I have no interest in the junk fund or the munis. Thus far it has worked very well.
Have you ever gotten a different amount at maturity than you paid for the shares?
https://www.bogleheads.org/forum/viewtopic.php?t=6212
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Re: iShares iBonds investment-grade ETFs - what happens if bonds are downgraded?

Post by shipbuilder »

anon_investor wrote: Fri Jun 17, 2022 11:06 am In your situation I would probably just get munis.
That's what I'm thinking. Thanks for the help assessing the issue.
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Re: iShares iBonds investment-grade ETFs - what happens if bonds are downgraded?

Post by shipbuilder »

grabiner wrote: Fri Jun 17, 2022 4:05 pm Whether the funds sell or keep bonds which fall below investment grade, you would expect them to slightly underperform the SEC yield. If a fund sells a bond that is downgraded to junk, it will sell at a loss. If it holds the bond, it may take a larger loss if the bond defaults.
This is a helpful way to think about the issue. The after-tax yield on the investment-grade fund is a bit higher than the after-tax yield on the muni fund. However, based on the distribution of credit quality, the investment-grade fund is probably going to underperform its SEC yield by more than the muni fund. So, in the end, the expected returns of the investment-grade and muni funds are probably similar, and the muni fund is less risky. Particularly given my goal of a defined nominal outcome, this makes the muni fund the better choice.
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Re: iShares iBonds investment-grade ETFs - what happens if bonds are downgraded?

Post by mega317 »

Be a hero and buy both, and report back in 3 and a half years.
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Re: iShares iBonds investment-grade ETFs - what happens if bonds are downgraded?

Post by bilperk »

My understanding is that any bonds that mature within 6 months of the end date are replaced with st reserves. It would seem if one bought the 2023 version, that the results might be less than expected?
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Re: iShares iBonds investment-grade ETFs - what happens if bonds are downgraded?

Post by JackoC »

shipbuilder wrote: Fri Jun 17, 2022 5:58 am 1. If I buy a large collection of BBB bonds and hold to maturity, some may be downgraded and some of those may default, but I will get the expected amount of money from those that don't default. My return will be something like (yield to maturity)*(1-default rate) + (loss given default)*(default rate). Will the ETF behave the same way? It seems possible that downgrades could cause the ETF to underperform a collection of bonds held to maturity because the ETF has to sell when the downgrade occurs and may get a low price at that time (after all, lots of other funds and asset managers will be selling, too). Is that right?

2. If so, can the effect be mitigated by buying a high-yield bond ETF whenever the investment-grade ETF is selling due to downgrades (so that, on net, one is continuing to hold the same set of bonds)?
1. You've recognized a relatively significant potential difference between the return of funds which continuously maintain a minimum rating of BBB and buying a bunch of investment grade corporate bonds and holding them to maturity or default, whichever comes first. Let's ignore the treasury yield curve effect of that (constant duration from the fund, declining duration from the pile of bonds bond held to maturity/default) and concentrate on the credit effect. The fund is always basically* composed of investment grade bonds, the pile of initially investment grade bonds gradually contains a larger and larger component of junk bonds as time goes on. The first portfolio is safer from direct defaults, that must cost something. In theory the losses from selling downgraded bonds at a wider spread than where bought would be equal to the avoided default losses by some of the jettisoned bonds ending up defaulting. But historically the cost of selling off bonds downgraded to junk has considerably exceeded the default losses of keeping them come what may.

So why do the funds do that? Basically because it be less transparent to compare funds and indexes if they had significantly different %'s of junk ex-investment grade ('fallen angel') bonds depending when they started (or grew the portfolio). It's similar to the reason leveraged ETF's rebalance daily, though most data would say the volatility drag could be reduced by rebalancing a little less often. But how you compare the 3.1 times fund to the 2.8 times fund? Regulation, and advertising, work better when things are simplest. But funds don't necessarily work better as investments by being simplest. Especially bonds which are less risky than stocks but more complicated.

In 'Expected Returns' Illmanen gave the following data: The Lehman/Barcap investment grade corporate index from 1973-2009 averaged a 120 bp option adjusted (that is for issuer call value) ex-ante spread over comparable maturity treasuries. But the actual ex post return was only treasuries plus 30. A lot of the drag was estimated to be from the factor you've identified, though other problems were also identified**.

2. That might work. It's complicated obviously by the fact the IG corp drag is caused by a certain type of company that goes from IG to junk, and junk funds have a lot of the somewhat different companies with a business model based on more leverage/risk to begin with. I find IG corp index a not very desirable asset class, I wouldn't bother, with some exceptions**. I think junk can be a desirable asset class under certain restrictions: viewed as at least partly an allocation to risk assets not a 'safe' alternative, and historically partly because of the fall angel effect junk funds like Vanguard's which concentrate more in the BB/B range and less in CCC and below have better risk v. return record than index junk funds with lower average rating. The best return v risk performance of corp bonds historically is the BB range, where the flip side of the barrier effect was greatest.

I'd note same effect would somewhat impact muni funds but less so because the typical funds have a much smaller % of bonds near the IG/junk barrier than IG corp funds do, especially nowadays.

*many funds of this general type are technically active, not strictly forced to jettison junk, but they generally still do.
**some investors are constrained by a 401k plan to buy a 'total bond' fund which is has moderate exposure to IG corps, not a big problem in the big picture IMO. Also the statements made apply more to medium/long corps than short. Short IG corp funds have worked better, ie another problem of medium term IG indexes historically is removing bonds when maturity is too short, but a lot of the risk adjusted juice is in the final years.
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Re: iShares iBonds investment-grade ETFs - what happens if bonds are downgraded?

Post by grabiner »

shipbuilder wrote: Sat Jun 18, 2022 7:28 am
grabiner wrote: Fri Jun 17, 2022 4:05 pm Whether the funds sell or keep bonds which fall below investment grade, you would expect them to slightly underperform the SEC yield. If a fund sells a bond that is downgraded to junk, it will sell at a loss. If it holds the bond, it may take a larger loss if the bond defaults.
This is a helpful way to think about the issue. The after-tax yield on the investment-grade fund is a bit higher than the after-tax yield on the muni fund. However, based on the distribution of credit quality, the investment-grade fund is probably going to underperform its SEC yield by more than the muni fund. So, in the end, the expected returns of the investment-grade and muni funds are probably similar, and the muni fund is less risky. Particularly given my goal of a defined nominal outcome, this makes the muni fund the better choice.
What is your marginal tax rate? That affects the after-tax yield of munis versus corporate bonds of comparable risk. My rule of thumb is that 25% is break-even, so that a corporate bond yielding 4% and a muni bond yielding 3% have comparable risk levels (although they may have different risks since more munis are callable). If your marginal tax rate is higher than 25% (which could be 24% federal tax plus 3.8% NIIT, or 22% federal tax plus state tax if you are using munis from your high-tax state), I recommend munis.
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Re: iShares iBonds investment-grade ETFs - what happens if bonds are downgraded?

Post by mega317 »

shipbuilder wrote: Sat Jun 18, 2022 7:28 am So, in the end, the expected returns of the investment-grade and muni funds are probably similar, and the muni fund is less risky. Particularly given my goal of a defined nominal outcome, this makes the muni fund the better choice.
What did you end up doing?
I bought the funds and will follow along with the performance.
https://bogleheads.org/forum/viewtopic.php?t=380398
https://www.bogleheads.org/forum/viewtopic.php?t=6212
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