Corporate Bond Funds
Corporate Bond Funds
Corporate bond funds offer higher yields than government bonds by accepting credit risk. Investment-grade corporates (LQD) carry lower default risk; high-yield corporates (HYG) offer higher yields but greater volatility.
Key takeaways
- Corporate bonds are issued by companies and offer yields 100-500+ basis points above comparable Treasuries, compensating for default risk.
- LQD (iShares Investment Grade Corporate Bond ETF) holds bonds rated BBB or higher, roughly 2,000+ issues with minimal default risk.
- HYG (iShares High Yield Corporate Bond ETF) holds bonds below BBB (BB and lower), offering 4-6% higher yields but with meaningful default and interest rate risk.
- Credit spreads (the yield premium corporates pay over Treasuries) widen during economic stress and compress during growth. Timing spreads is a form of market timing.
- For most investors, limiting corporate exposure to 20-35% of a bond portfolio, concentrated in investment-grade issues, is prudent.
The spread concept
The core of corporate bonds is the spread: the yield difference between a corporate bond and a comparable Treasury. A 10-year Apple bond might yield 4.8% when the 10-year Treasury yields 4.0%, a spread of 80 basis points (0.8%). This spread compensates investors for the risk that Apple might default (extremely unlikely, but non-zero) and for lower liquidity.
Spreads vary by credit quality. AAA-rated companies (Microsoft, Berkshire Hathaway) might borrow at Treasury yield + 40 basis points. BBB-rated companies (near the investment-grade boundary) might borrow at Treasury yield + 120 basis points. Below-investment-grade companies (speculative or "junk" issuers) might borrow at Treasury yield + 300-600 basis points.
Spreads also vary cyclically. In a strong economy, companies are profitable and defaults are rare, so investors demand less spread—perhaps 60 basis points over Treasuries. In a weak economy, when recession looms and defaults rise, investors demand more spread—perhaps 200 basis points. This spread widening and tightening creates capital gains and losses independent of interest rate moves.
In March 2020, when the pandemic triggered a sharp economic shock, investment-grade spreads widened from 100 basis points to over 300 basis points. An investor holding LQD experienced both interest rate losses (as Treasuries rallied and long-term rates fell) and spread losses (as the average corporate bond's yield climbed). The dual headwind created a sharp drawdown. Then, as the Federal Reserve announced emergency purchases of corporate bonds, spreads compressed, and LQD recovered strongly by mid-2020.
Investment-grade corporates: LQD
LQD holds U.S. corporate bonds rated BBB or higher (investment-grade). This includes roughly 2,000 issues from companies across all sectors: technology, finance, healthcare, energy, consumer goods, industrials, and utilities. As of early 2025, the fund's composition approximates:
- 35% financial sector
- 25% technology and communication
- 15% industrial
- 12% utilities
- 8% healthcare
- 5% other sectors
LQD's expense ratio is 0.14%, slightly higher than the aggregate fund's 0.03% but justified by the additional complexity of sourcing and holding corporate bonds. As of early 2025, LQD yields approximately 5.2-5.4%, roughly 100-150 basis points above comparable Treasury yields, compensating for credit risk.
The default rate for investment-grade corporate bonds is typically under 0.5% annually in normal times, rising to 2-4% during severe recessions. The default recovery rate (what investors recover from defaulted bonds) is typically 40-60 of par. So an investment-grade bond yielding 100 basis points above Treasuries is actually being compensated more than adequately for historical default risk. This is the case for holding corporates: the yield is real, and the default risk is remote.
Over the past 10 years (2014-2024), LQD returned approximately 3.2% annualized, about 0.9% above the aggregate fund, entirely from higher yield. The price appreciation was minimal; the outperformance was the coupon.
High-yield corporates: HYG
HYG holds U.S. corporate bonds rated below BBB (speculative-grade, or "high-yield" or "junk" bonds). These are bonds from companies with weaker credit profiles: smaller, more leveraged, or cyclical firms. Some of HYG's holdings include bonds from highly leveraged companies in the telecom, cable, and retail sectors. The fund holds roughly 1,500-2,000 issues.
HYG's expense ratio is 0.48%, significantly higher than LQD, reflecting the complexity of managing a portfolio of less liquid, less stable issuers. As of early 2025, HYG yields approximately 7.5-8.0%, roughly 350-400 basis points above Treasuries, compensating for higher default risk.
The default rate for high-yield bonds is typically 2-5% annually in normal times, rising to 10-15% during severe recessions. During the 2008-2009 financial crisis, high-yield default rates exceeded 12%. This means an investor holding HYG should expect to lose money to defaults at a regular rate—not a bug, but a feature. The 350+ basis point yield compensates for this expected loss.
Over the past 10 years, HYG returned approximately 5.5% annualized, about 2.2% above the aggregate fund. But this performance includes the extraordinary 2012-2019 period, when credit spreads were exceptionally tight (low yields, high prices). From 2020 onward, spread volatility increased. In 2022, HYG fell 18% as spreads widened sharply. In 2023-2024, spreads compressed and HYG recovered.
HYG is not for passive investors. It is a cyclical holding that rewards investors who buy when spreads are wide (and prices are depressed) and sell when spreads compress (prices appreciate). Buy-and-hold investors in HYG will capture the extra yield but also endure sharp drawdowns every few years.
Sector concentration and diversification
LQD's holding of 2,000+ investment-grade bonds across all sectors provides broad diversification. Even a 1% default in any single sector would have minimal impact on the fund. The diversification is real.
HYG, despite holding 1,500-2,000 issues, is less diversified. Many issuers are concentrated in economically cyclical sectors—energy, materials, consumer discretionary—that tend to default together during recessions. In the 2020 pandemic shock, companies in the travel, hospitality, and energy sectors faced acute stress. An investor who thought HYG was holding 1,500 uncorrelated defaults would have been surprised to see the fund sell off sharply when correlations spiked.
For a portfolio, complementing HYG with other assets that perform well during economic stress (Treasuries, defensive stocks) is essential. HYG is best held as a satellite position (10-15% of a bond portfolio) rather than a core holding.
Liquidity and bid-ask spreads
Corporate bonds trade in the OTC market, not on an exchange. Liquidity varies by bond. Large issuers (Apple, Microsoft, Berkshire Hathaway) have bonds with tight bid-ask spreads (perhaps 0.05% on either side of mid). Smaller, less-frequently-traded issuers might have spreads of 0.5-1.0%.
ETFs sidestep this by aggregating trades. LQD and HYG trade on exchanges with tight spreads (typically $0.01 per share on a $100+ share price), insulating investors from bond market illiquidity. The ETF structure allows small investors to trade corporate bonds as easily as stocks.
Maturity and duration
Both LQD and HYG hold bonds across a range of maturities. LQD's duration is typically 5-7 years, similar to the aggregate fund. HYG's duration is typically 3-5 years due to the prevalence of shorter-maturity high-yield issues (companies with poor credit ratings don't issue 30-year bonds; they can't). This shorter duration makes HYG less sensitive to interest rate changes but more sensitive to credit risk.
Tax efficiency and account placement
Corporate bond distributions are ordinary income, taxed at your marginal rate, just as Treasury interest is. There is no preferential tax treatment. In a taxable account, corporate bond funds are suboptimal relative to holding them in a tax-deferred account. A 401k or IRA is the right place for LQD or HYG.
Determining allocation to corporates
A standard allocation for a bond investor might be:
- 50-70% Treasuries or aggregate bonds (mix of government, agency, and MBS)
- 20-35% investment-grade corporates (LQD)
- 0-10% high-yield corporates (HYG), only for investors with explicit risk tolerance and the ability to endure periodic drawdowns.
A retiree living off bonds should be 80%+ in Treasuries or aggregate bonds, with minimal corporate exposure. A young investor with 30+ years to retirement can take more corporate exposure; if spreads widen and bonds sell off, they have decades to benefit from the extra yield and wait for recovery.
An investor in a strong conviction that spreads are going to widen (economy deteriorating) should reduce corporate exposure before the widening occurs. An investor who believes spreads are going to compress (economy strengthening) should increase corporate exposure. But most investors should avoid trying to time spreads—it is a form of market timing, and market timers consistently underperform.
Cost and expense ratio reality
LQD at 0.14% and HYG at 0.48% are not expensive in absolute terms. But relative to 0% (owning individual corporate bonds directly) or to the aggregate fund's 0.03%, the expense ratio adds up. Over 20 years, a 0.11% annual drag (LQD vs. aggregate) is 2.2% of returns foregone. This matters for large positions.
However, for most investors, the convenience of owning a diversified basket of 1,500+ bonds far outweighs the expense ratio. Constructing a corporate bond ladder from individual issues would require tens of thousands in minimum orders and is impractical for small accounts.
Next
Corporate bonds provide higher yield at the cost of accepting credit risk. Many investors want additional yield without corporate credit risk. TIPS offer another path: inflation protection from Treasury bonds. The next article explores TIPS funds and when inflation protection is worth buying.