Cheap Exposure to Investment-Grade Corporate Bonds

The Bloomberg Barclays U.S. Aggregate Bond Index, which is the most common benchmark for the U.S. investment-grade market, has less credit risk than most of its peers, skewing toward low-yielding Treasury bonds and agency mortgage-backed securities. Investors looking for higher potential returns without straying beyond the investment-grade universe or taking greater interest-rate risk might consider a low-cost corporate-bond fund like

This exchange-traded fund provides market-cap-weighted exposure to investment-grade U.S. corporate bonds with between five and 10 years until maturity. It is one of the lowest-cost options in the corporate-bond Morningstar Category and has tightly tracked the Bloomberg Barclays U.S. 5-10 Year Corporate Bond Index. While there's plenty to like here, it's important to note that this fund has heavy exposure to the financial-services sector, which could be a source of risk. It earns a Morningstar Analyst Rating of Silver.

Roughly one third of the portfolio is invested in the financials sector. Its average sector exposure was less than one fourth of the portfolio from 2010 to 2016, according to Morningstar data. Any negative developments in this sector could hurt the fund's performance. This concentration is mostly driven by large U.S. banks, which have issued a record amount of debt since 2010 to take advantage of low rates and meet the strict post-crisis capital requirements. Consequently, market-cap weighting steered the fund toward A and BBB rated financial institution bonds. These bonds have low default risk and offer a higher yield than Treasury securities with comparable terms.

VCIT's duration is in line with its category peers. As of February 2018, its duration was 6.4 years compared with the category average of 6.2 years. This fund is likely to respond to rate movements in a similar way to its peers.

Effective management has kept the fund close to its index. From March 2013 to February 2018, the fund produced an annualized return of 2.8%, lagging its benchmark by 0.1%. This gap is on par with its 7-basis-point expense ratio, which gives it a sustainable cost advantage over 90% of its category peers. This fund's five-year annualized return through February 2018 was also 10 basis points behind the typical category peer that dabbles in higher-yielding bonds and junk bonds. Its Sharpe ratio, a risk-adjusted-return measure, was on par with the category average during the same period.

Fundamental View Investing in a broad market-cap-weighted bond index has its advantages. For a low fee, an indexed portfolio replicates the composition of the fixed-income market and reflects the collective views of market participants about the value of each security. But there are some drawbacks.

Market-cap weighting skews the portfolio toward the largest debt issuers, which may or may not offer the best potential returns. In the intermediate investment-grade corporate fixed-income market, there have been record debt issuances by U.S. financial institutions in recent years. For example, financial companies issued more than $130 billion of debt between Jan. 1, 2018, and March 15, 2018, according to J.P. Morgan. The issuances were largely driven by low rates and post-crisis regulatory changes.

Accordingly, the portfolio is biased toward the financial-services sector, which accounted for more than 33% of the portfolio as of February 2018. This concentration makes the fund vulnerable to sector-specific risk. Its category peers typically allocate about one fourth of their portfolios to financial institution bonds.

The portfolio is concentrated on the lower end of the investment-grade spectrum, with considerable exposure to bonds rated A and BBB. These securities take up nearly 90% of the portfolio. This concentration is driven by U.S. banks and the recent surge in debt issuances related to mergers and acquisitions by telecommunications firms. VCIT's typical category peer invests roughly three fourths of its assets in A and BBB rated bonds. The balance of its assets is divided between higher-credit-quality and below-investment-grade securities. The fund, however, does not invest in high-yield securities.

While the fund's sector and credit-rating distribution differs from the corporate-bond category average, its duration-risk profile is similar. As of February 2018, its duration was 6.4 years, virtually the same as the category average. The fund will likely move in tandem with its category peers when rates move.

The strategy's three- and five-year annualized returns of 2.2% and 2.8% were behind the category average. This underperformance was driven principally by the portfolio's relatively conservative construction that excludes below-investment-grade bonds. Its risk-adjusted returns, measured by Sharpe ratio, were in line with the category average over the same periods thanks to its significant cost advantage.

Portfolio Construction VCIT earns a Positive Process Pillar rating because it accurately captures its target investment universe, which is sensible and investable, at a low cost. Also, this fund skews toward the most-liquid securities, lowering transaction costs.

The fund employs a sampling approach designed to track the performance of the Bloomberg Barclays U.S. 5-10 Year Corporate Bond Index. This index includes U.S.-dollar-denominated, investment-grade, fixed-rate, taxable securities with between five and 10 years until maturity. The minimum par amount outstanding is $250 million. VCIT holds a range of securities that, in aggregate, approximate the full index in terms of key risk factors, including credit quality and duration, sector composition, and other characteristics. The fund maintains a dollar-weighted average maturity consistent with that of the index. It rebalances on the last business day of each month.

Fees This fund receives a Positive Price rating because of its cost advantage over its category peers. VCIT charges 7 basis points compared with the category median fee of 0.65%. In fact, it is cheaper than 90% of its peers. Moreover, this fund tracked its benchmark tightly. From its inception in November 2009 through February 2018, the fund lagged its benchmark by 10 basis points annually.

Alternatives

Silver-rated

Disclosure: Morningstar, Inc. licenses indexes to financial institutions as the tracking indexes for investable products, such as exchange-traded funds, sponsored by the financial institution. The license fee for such use is paid by the sponsoring financial institution based mainly on the total assets of the investable product. Please click here for a list of investable products that track or have tracked a Morningstar index. Neither Morningstar, Inc. nor its investment management division markets, sells, or makes any representations regarding the advisability of investing in any investable product that tracks a Morningstar index.