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ETF Specialist

This Fixed-Income ETF Has Its Trade-Offs

This high-yield bond index fund attempts to avoid some of the pitfalls of market-cap weighting, but it may introduce a new problem.

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Traditional market-capitalization-weighted bond indexes get a lot of flak for assigning the largest weights to the most-heavily-indebted issuers. For instance, it may not be optimal for investors to hold more  General Motors (GM) debt just because GM needs to raise more money. Market-cap-weighted equity indexes share this potential drawback. Companies that issue stock can increase their market capitalizations without any changes in the fundamentals of the business, simply by raising more cash through the sale of additional shares to the public. However, this issue is likely less pronounced for stock than bond indexes because most companies rely more heavily on debt financing. Skewing toward the most-indebted issuers may be particularly problematic in the high-yield bond market because these issuers may carry greater default risk than their less indebted counterparts. The biggest debtors may also be more likely to suffer a credit-rating downgrade, which could hurt performance.

 PowerShares Fundamental High Yield Corporate Bond (PHB) attempts to address this issue by weighting its holdings according to fundamental measures of their issuers' size, including sales, cash flow, dividends, and the book value of their assets. This approach may give the fund less exposure to heavily indebted companies than its peers that weight their holdings by the market value of each issue. But where market-cap weighting offers the advantage of tilting a portfolio toward the most-liquid bonds, this fund may overweight some of the less liquid issues. These bonds can be more difficult to obtain and more expensive to trade. In order to limit this potential problem, the fund's benchmark, the RAFI Bonds US High Yield 1-10 Index, restricts its holdings to issues with at least $350 million in par value outstanding.

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Alex Bryan does not own shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.