Big Doesn't Mean Bad for Corporate Bond ETFs

(Editor's Note: This is an article that was originally written in 2018 and accidentally republished with today's date on it. The information herein is old and no longer reliable. We apologize for the error.)

Weighting stocks by market value is the most frequently used weighting scheme among index funds and exchange-traded funds (ETFs). This is also true among fixed income ETFs, including corporate bond funds.

What that means is that the largest holdings in traditional corporate bond ETFs, such a the iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD), are the biggest issues. So if hypothetical company XYZ Inc. sells $1 billion worth of investment-grade corporate bonds, that issue's weight in a fund like LQD would be bigger than the weight assigned to a $500 million issue from mythical ABC Corp.

The good news for investors is that this weighting methodology is not as risky as it may seem at first glance. "It may seem intuitive to conclude that the largest debtors are the riskiest, which has led to the idea that these index funds are poor investments," said Morningstar. "This notion is inaccurate, particularly in the investment-grade realm. The largest issuers tend to be large enterprises with the cash flow necessary to support their debt. They are not necessarily more leveraged or riskier than smaller issuers." (See also: Evaluating Bond Funds for Performance and Risks.)

The $34.74 billion LQD, the largest corporate bond ETF by assets, tracks the Markit iBoxx USD Liquid Investment Grade Index and holds over 1,900 bonds. None of the ETF's holdings represent more than 2.95% of the fund's weight. Due to significant corporate debt issuance during the global financial crisis, the financial services sector is often the largest sector weight in corporate bond funds. That is true of LQD, which allocates nearly 28% to that sector.

Although financial services issues represent six of LQD's top 10 holdings, that group also includes corporate debt issued by Apple Inc. (AAPL) and Microsoft Corporation (MSFT). Fortunately for investors, large issues do not mean that the issuer is overly leveraged.

"From 2007 to 2017, the largest 10 U.S. corporate issuers' median leverage, as measured by debt/EBITDA, was on par with the median leverage of all publicly traded U.S. issuers, according to estimates by Goldman Sachs," said Morningstar. "The median leverage ratio for the largest 10 issuers hovered slightly below 3.0 times, and the corresponding figure for all publicly traded issuers was slightly above 2.5 times."

In many cases, companies that are highly leveraged risk junk ratings, but over 88% of LQD's holdings are rated A or BBB. Nearly 8% carry AA ratings. From 2002 through 2017, 45 issues resided among LQD's top 10 holdings, but just two lost their investment-grade ratings over that period, according to Morningstar. (For additional reading, check out: Corporate Bonds: An Introduction to Credit Risk.)