Cheap Access to the Investment-Grade Bond Market

Bond funds can help diversify a portfolio, generate stable cash flows, and provide downside protection. However, some bond funds may take on additional credit or interest-rate risk to provide better returns than more-protective peers. While taking on additional credit risk can help performance in the short term, it can make an investor's bond portfolio more correlated to equities and reduce its diversification and protection benefits during periods of market turmoil. Investors looking for a core bond portfolio with a high-quality tilt may consider

The fund targets fixed-rate, investment-grade government, corporate, and securitized bonds that are denominated in U.S. dollars and weights its holdings by float-adjusted market capitalization. As a result, the portfolio skews heavily toward government and securitized bonds, which account for about 70% of the portfolio, much greater than the intermediate-bond Morningstar Category average (20%) as of March 31, 2015. This gives the fund a high-quality portfolio. The average credit rating of its holdings is A, which is higher than its average intermediate-term bond peer's (BBB). While that may help the fund hold up better when equities or lower-quality bonds sell off, it can also result in lower expected returns amid credit rallies or risk-seeking environments. Further, the fund's duration of 5.3 years is longer than the category average of 4.9 years. That could hurt the fund's relative performance in a period of rising interest rates. However, the fund's diversification across the yield curve can reduce this risk.

Low fees give this exchange-traded fund a sustainable edge. It charges a rock-bottom 0.08% expense ratio (after 0.01% expense waiver expiring June 2015), while the median mutual fund in the category charges 0.65%. In a low-interest-rate environment, it may be especially difficult for more-expensive funds to overcome this cost hurdle--even if a manager's interest-rate and credit-risk bets are correct. For instance, over the trailing 10 years through March 2015, the fund's total annualized return (4.8%) was greater than that of its actively managed counterparts (4.6%), despite its lower yield. The fund's market-cap-weighting approach also helps reduce transaction costs because it tilts the portfolio toward the most-liquid issues, which tend to be cheapest to trade and can reduce its total cost of ownership relative to actively managed funds.

Over the trailing 10-year period, the fund's annualized gain landed in the middle of the intermediate-term bond category. While the fund's cost advantage was offset by the lower return it earned on its higher-quality bonds, it did so with less volatility than the category average. During that stretch, the standard deviation of the fund's return (3.3%) was less than that of its actively managed peers (3.9%). More importantly, this quality tilt has helped the fund hold up better during rough equity markets. For instance, in 2008, the fund had greater returns (5.9%) than the average actively managed fund in the intermediate-bond category (negative 3.3%). It is difficult for active managers to beat this index net of fees without taking more credit or interest-rate risk.

Fundamentals During the past six years, credit spreads between intermediate-term U.S. corporate and Treasury yields compressed to near all-time lows. However, over the trailing year through March 2015, corporate-credit spreads have begun to widen relative to U.S. Treasuries. As of March 31, 2015, the spread between intermediate-term corporate bonds and Treasuries, as measured by the difference between the Bank of America Merrill Lynch U.S. Corporate Master Index and the 10-year Treasury, was 1.0%. While this is above its one-year low (0.4%), it is below its trailing 15-year average through March 2015 (1.3%). This means that the corporate bonds within the fund may underperform if credit spreads continue to widen.

The Federal Reserve has stated that it may look to raise interest rates in 2015. While the March 2015 U.S. unemployment rate was 5.5% (a rate not seen since before the financial crisis), March 2015 inflation was only 0%, which was below the trailing 20-year average (2.4%). With inflation low, there may be no rush for the Fed to increase short-term interest rates. Further, inflation may remain low in the near term as a result of lower energy prices and a strong U.S. dollar. Energy prices represent about 10% of the Consumer Price Index. Over the trailing 20 years through March 2015, the correlation between energy, as measured by the WTI crude price, and changes in the CPI was 0.93. A strong dollar can make imported products less expensive, reducing the cost of everything from oil to consumer products.

While corporate bonds are more risky than U.S. Treasuries, U.S. companies currently have more cash on their balance sheets than ever before. The last time an investment-grade-rated company defaulted was 2011, and the average default rate since 1981 for investment-grade debt is 0.12%, according to the 2013 Annual U.S. Corporate Default Study and Rating Transitions, published by S&P. The fund's corporate-bond holdings have an average credit rating of A, which has an average historic default rate of 0.08%, according to that report.

Portfolio Construction The fund tracks the Barclays U.S. Aggregate Bond Index, which measures the total investment-grade, U.S. dollar-denominated, fixed-rate bond market. The index includes corporate, government, and securitized bonds and is widely used as a proxy for the U.S. bond market. Corporate issuers include industrial, financial, and utility companies. Securitized bonds include agency mortgage-backed securities and other asset-backed securities. The index weights its holdings by market capitalization and rebalances at the end of each month. This gives the most heavily indebted issuers--like the U.S. government--the greatest weightings in the portfolio.

The fund uses a sampling strategy to track its index and holds roughly 3,400 of its index's 9,000 constituents. This has helped the fund keep its tracking error to the index low. Over the trailing three years through March 2015, the fund's tracking error to its index was only 0.09%.

Fees The fund charges a 0.08% expense ratio (after a 0.01% expense waiver expiring June 2015), making it one of the cheapest aggregate-bond ETFs available. Over the trailing three years through March 2015, the fund's performance lagged its benchmark by 0.05%, which is in line with its fee.

Alternatives

Investors looking for an actively managed ETF may consider

Disclosure: Morningstar, Inc.'s Investment Management division 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.