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Tickers in this Article: AGG, BND, CBND, FLTR, IBND, PHB, PICB
Innovative new ETFs now offer traders and investors looking to tap into the investment grade corporate bond space some distinct advantages. Here, a fund expert profiles several new products.

Innovation has become a hallmark of the ETF industry in recent years, as new and existing issuers alike have rolled out increasingly complex and creative products that have further expanded the universe of asset classes and investment strategies available through exchange traded products (ETPs).

Perhaps no corner of the ETF lineup has grown as quickly as the investment grade corporate bond space. At the beginning of 2009, there were only four ETFs in the ETFdb corporate bonds category with aggregate assets of about $8 billion.

As investors and traders have become more comfortable with the combination of fixed income exposure and ETFs, both products and assets have skyrocketed. There are now 23 ETFs in this category with a total of nearly $30 billion in assets under management (AUM) at the end of May.

Much like the rest of the ETF industry, this growth has been marked by innovation, as opposed to duplication. Guggenheim introduced a suite of target maturity date bond ETFs that feature a “yield profile” that more closely resembles individual fixed income securities.

Van Eck rolled out a product that invests in floating rate corporate debt, the Market Vectors Investment Grade Floating Rate ETF (FLTR). The PowerShares International Corporate Bond Portfolio (PICB) and SPDR Barclays Capital International Corporate Bond ETF (IBND) are both ETFs that invest in corporate debt of ex-US issuers.

But perhaps the biggest breakthrough in the corporate bond arena came earlier this year with the introduction of the SPDR Barclays Issuer Scored Corporate Bond ETF (CBND), a product that takes a fundamentally different approach to delivering exposure to an asset class that is a core component of many fixed income portfolios.

Fundamental Approach

Adoption of bond ETFs has been relatively slow, in part because investors have only gradually become aware of the potential benefits of ETFs, including lower expenses, enhanced transparency, and potentially superior tax efficiencies. But the adoption process has also been slow because of some concerns about the manner in which fixed income exposure and the exchange traded structure combine.

The indexes to which many fixed income ETFs are linked weren’t necessarily designed as investable assets. The BarCap Aggregate Index that the iShares Barclays Aggregate Bond Fund (AGG) and the Vanguard Total Bond Market ETF (BND) seek to replicate, for example, has some 8,000 individual components, many of which trade irregularly. And most bond ETFs maintain a constant duration across time, maintaining a steady focus on debt with a maturity within a certain window relative to the present.

Another common characteristic is a market capitalization weighting methodology that gives the largest index allocations to the largest issuers of debt. Just as there are potential pitfalls to cap-weighting strategies in index-based equity products—such as the tendency to overweight overvalued stocks and underweight undervalued stocks—building an investable asset on the fixed income side of the portfolio can be less than optimal. A greater debt burden will generally translate into a greater strain on cash flows, which can reduce the creditworthiness of an issuer.

(Incidentally, this feature may also explain the increased interest in corporate bond ETFs in recent years. As the US government’s debt burden has ballooned, the allocation to Treasuries in total bond market ETFs has similarly grown, and those seeking more balanced exposure to the investment grade debt market have perhaps felt compelled to complement ETFs such as AGG or BND with additional corporate debt.)

NEXT: New Funds Allow for Alternative Strategies

Alternative Strategies

A number of alternatives to cap weighting have popped up on the equity side in recent years, with ETFs offering exposure to equal weighting, dividend weighting, revenue weighting, and multi-factor fundamental weighting all bursting on to the scene (and many of them attracting significant assets).

But the push to unveil alternatives to cap-weighting in fixed income products has unfolded a bit more slowly. Last summer, PowerShares switched the focus of an existing junk bond ETF, deciding to have its PowerShares Fundamental High-Yield Corporate Bond Portfolio (PHB) seek to replicate an index based on the RAFI methodology that has become popular in many equity ETFs.

And now, State Street has put its own twist on the fundamental weighting game, coming up with an investment grade corporate bond product that takes a unique approach to selecting issuers to be represented.

Fundamental Difference

Instead of giving the largest allocations to the biggest debtors, the index to which CBND is linked uses three fundamental factors to determine the weight given to each issuer among those in the eligible universe:

  1. Return on assets (ROA): Net income divided by total assets
  2. Interest coverage: Earnings before interest and taxes (EBIT) divided by interest expense
  3. Current ratio: Current assets divided by current liabilities
These ratios will actually favor issuers with more manageable debt burdens, as lower interest obligations translate into higher ROA and interest coverage metrics. So the bias towards those issuers with big debt burdens is replaced by a bias towards companies with strong cash flows and high credit qualities, a tilt that can create a unique risk/return profile relative to other corporate bond ETFs.

“When you think about capitalization weighting in stocks, the drawbacks are fairly evident,” said Research Affiliates founder Rob Arnott in an interview last year. “When you talk about cap weighting in bonds, the drawbacks are flagrantly obvious.”

For investors who agree with Arnott and maintain concerns about the combination of fixed income exposure and cap weighting methodologies, CBND may represent a major step forward in the evolution of bond ETFs.

As the relative performance of various equity ETFs has shown, the choice of weighting methodology is not a minor decision; the strategy used to determine individual allocations within a portfolio can have a major impact on both bottom line returns and volatility.

Enhanced Flexibility

An increase in the allocation to Treasuries within broad-based bond ETFs has corresponded with a steady drop in interest rates, creating an environment where inclusion of investment grade corporate bonds can provide both a better balance of fixed income exposure and sufficient current income.

More options in this asset class have given investors tools to fine tune corporate debt exposure in order to better meet the needs of an individual portfolio.

By Michael Johnston of ETFdb.com

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