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Any glaring risks in a fund like LQDH?

hank
edited August 27 in Fund Discussions
Just uncovered this strategy. There are other similar bond funds that track the same index. Blackrock's price is probably one of the best. As I understand the strategy, they go long investment grade corporate bonds and hedge rate risk by going short U.S. Treasuries of a similar duration. Held up well in 2022 compared to most bond funds, Apparently attempting to harvest the excess return of corporates over Treasuries.

My thought here is it might perform better than a short-term bond fund over time at a similar cost and without a lot more credit or duration risk.

What’s the unseen risk here? What could cause these vehicles to blow up?

Comments

  • yogibearbullyogibearbull
    I don't see any direct short Treasury positions.
    Basically, it holds corporate LQD & tons of rate-swaps plus supporting cash. Duration is very low. So, the overall effect is m-mkt like returns out of intermediate-term bonds overlaid with derivatives. But the current yield is well below VMFXX, so, what's the point?
  • hank
    edited August 27
    yogibearbull said:

    I don't see any direct short Treasury positions.
    Basically, it holds corporate LQD & tons of rate-swaps plus supporting cash. Duration is very low. So, the overall effect is m-mkt like returns out of intermediate-term bonds overlaid with derivatives. But the current yield is well below VMFXX, so, what's the point?

    I’m not sure that’s a fair comparison, With the present inverted yield curve money market funds should yield better than longer dated bonds. Were yield the only factor nobody would invest in longer dated bonds today. Any (perceived) advantage would accrue to someone who wanted to own longer term investment grade bonds for diversification and who thought the inverted curve will return to normal some day.

    * Isn’t the ultra low “effective” duration (0.15 years) really just a reflection of the hedging? Duno. Just trying to learn.

    Here’s a link to Blackrock / LQDH with some performance data. Seems to have outdistanced money market funds in recent years. - M* shows LQDH returning north of 3% annually over the past 10 years. That’s about double what money market funds achieved.

    Appreciate the comments from @yogibearbull
  • catch22catch22
    Looking at M* for the past several months, LQD has outperformed LQDH for each of the monthly periods. One might have expected better from LQDH in anticipation of rate cuts and their swaps, etc. The portfolio indicates 95% of the portfolio is LQD. Am I correct with this and what you see?

    You noted:
    M* shows LQDH returning north of 3% annually over the past 10 years. That’s about double what money market funds achieved.
    MMKT's were paying only about .01% yields for many years. As of April, 2022 the Fido MMKT's were paying .11% yield. This is when the move up to the current yields began. So, comparing to 10 years backwards against a MMKT yield 'is not valid'.

    6 month CHART of the two.
  • hank
    edited August 27
    Thanks @Catch - I agree LQD has done much better over time. But look at the 2022 performance of the 2 funds.

    While we can compare performance to other bond funds, I’m mostly interested in how the use of interest rate swaps to hedge rate sensitivity could blow up. Are there hidden dangers in this kind of hedging? On the surface it looks like a simple way to capture the difference between what Treasuries return and what investment grade corporates do. I’ve compared the return over 10 years to money market funds, short term bond funds and ultra-short bond funds. It seems to have done better - and on a reasonably consistent basis.
  • catch22catch22
    Hi@hank
    I'm fully past my pay grade to even guess what 'swaps' could do to cause damage to such a portfolio. My best guess is that management could get things wrong with their process es of using swaps.
    I'd have to pass on LQDH as part of our portfolio.
  • yogibearbullyogibearbull
    The FOMC started raising rates in 3/1/22, so here is the run from 3/1/22 from TestFol for LQD, LQDH, m-mkt VMFXX, ultra-ST ICSH. LQDH has definitely outperformed LQD, as expected due to rate-hedging. LQDH kept pace with VMFXX and ICSH until 4/30/23, but then outperformed subsequently. When the rates start to go down, LQD should shine - why hedge bond funds when rates are falling?
    LINK
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