Are There Viable Alternatives to Traditional Bond ETFs?

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. As bond index funds and exchange-traded funds have taken in more assets, some new strategies have begun to emerge. Joining to discuss this topic is Alex Bryan. He is director of passive strategies research for Morningstar in North America.

Alex, thank you so much for being here.

Alex Bryan: Thank you for having me.

Benz: Alex, let's start from the beginning and talk about traditional capitalization-weighted bond index funds, so funds that track the Barclays Aggregate Index, for example. What's the setup there for people who may not have thought through what capitalization weighting means for the fixed-income markets?

Bryan: Sure. So, a lot of these broad market-cap-weighted bond index funds are providing broad exposure to a certain segment of the market and then they are weighting their holdings based on market capitalization or the number of bonds that are outstanding times the market price of those bonds. What that means is that the larger borrowers receive larger weightings in the portfolio and for obvious reasons that may not be necessarily a desirable thing, but that's certainly the way that most traditional bond index funds have been weighted.

Benz: So, in practical terms, let's again go back to the Barclays Aggregate that tendency to overweight the biggest issuers or the necessity of overweighting the biggest issuers gives those Barclays Aggregate trackers a big emphasis on government bonds today.

Bryan: That's absolutely right. So, actually, as the government has been running deficits for many years, the weighting of government Treasuries and even agency mortgage-backed securities have become larger components of the Barclays Aggregate Bond Index. Now, what that's done is that's reduced the expected returns of that portfolio because government securities tend to offer lower yields because they tend to be a little bit less risky. So, that's the downside. Now, the plus side is that market-cap-weighting tends to require lower turnover than alternative weighting schemes and it also moves the portfolio to the more liquid securities so it can reduce implementation costs in that way.

Benz: In the most recent issue of ETFInvestor you took a look at some core bond ETFs that have hit the market that do explore non-cap-weighted strategies. Let's talk about those funds. There is one that you actually like within that context.

Bryan: So, that's the Wisdom Tree Barclays U.S. Aggregate Bond Enhanced Yield fund, ticker AGGY. It basically divides the Barclays Aggregate Bond Index up into 20 subcomponents and then reweights those subcomponents to try to maximize yield subject to several constraints to prevent it from taking too much risk. But it does take a little bit more credit risk and a little bit more interest-rate risk than the Barclays Aggregate Bond Index, but I like that fund because it charges a very low 12 basis points that gives you a little bit of extra return.

Benz: So, that's a more straightforward non-cap-weighted ETF. But let's talk about some of the funds that have hit the market that do use more complicated strategies.

Bryan: So, there's a few of them and they can be pretty tough to get a handle around, especially if you aren't familiar with these alternatively weighted approaches. But one I think that's kind of interesting is the IQ Enhanced Core Bond U.S. ETF, ticker AGGE. And that uses a momentum, a trend-following strategy to basically overweight certain segments of the bond market based on strong relative performance and that's based on this idea that relative performance tends to persist in the short term.

Now, as you could imagine, a momentum strategy in the bond universe can lead to very high turnover and that may not be appropriate for investors who are using bonds to play defense in their portfolio because the characteristics of that portfolio can change over time. And any time you are trading you have high turnover in the bond universe, the transaction costs could be quite high. So, to manage that this is structured as an ETF of ETFs, so it's trading five underlying ETFs as a way of trying to reduce the cost. But there is a bit of turnover and that's certainly a risk that investors need to be mindful of.

Another fund that uses a bit more of a complex approach is the iShares Edge U.S. Fixed Income Balanced Risk ETF. This is an actively managed ETF that tries to balance the amount of exposure it has to credit risk and the amount of exposure it has to interest-rate risk. It is doing this as a way of trying to improve diversification so that rather than thinking about diversification in terms of allocating capital across different bonds, it's looking at its risk exposure from these different factors and trying to diversify it that way. I think it's an interesting approach, but the complexity can give some investors pause.

Benz: So, in reading through your descriptions and your discussions of these various differently organized fixed-income ETFs, one theme that kind of comes through is that they are either taking more interest-rate risk, more duration risk, more credit risk. Their yields and in turn their return potential will tend to be higher but their volatility potentially might also be higher. So, I think the question is, do you think that these products in a diversified portfolio if an investor's goal is, well, I want some ballast for my equity holdings, is there a chance that these funds will do less well from that standpoint than a traditional cap-weighted index ETF?

Bryan: That's absolutely a valid concern. So, if you think about bonds as being the defense in your portfolio and equities being your offense, something like the Barclays Aggregate Bond Index that is market-cap-weighted does tend to be a bit more defensive than a lot of these alternatively weighted funds and that's because the Barclays Aggregate Bond Index has greater exposure to Treasuries and greater exposure to agency mortgage-backed securities.

So, these new strategies could be more volatile. They may not hold up quite so well during market downturns. But if you think about the roles that the bonds have traditionally played and the role that the Barclays Agg has traditionally played, that's actually historically been a more aggressive index than it is now. It's more heavy in Treasuries and agency mortgage-backed securities now than it has been even a decade ago. So, for many investors that's too conservative of a bond portfolio and you might consider taking a little bit more credit risk, for example.

That said, it is important not to take more risk than you can handle. So, I think it's reasonable to take on a modest amount of credit risk and still retain the conservative characteristics that bonds should play in a diversified portfolio. But it is important to note that any time you are picking up some additional yield, you are taking more risk.

Benz: Another topic you delved into in your article was the subgroup of funds that focus specifically on the corporate bond sector and you noted that there are some new constructions coming to market, some new ETFs coming to market. Let's talk about that area and kind of the thesis about why one might want to reorganize a capitalization-weighted corporate bond ETF.

Bryan: Sure. So, if we think about the thesis, so market-cap-weighting tends to skew the portfolio to the more heavily indebted issuers. So, when you're talking about something broad like the Barclays Aggregate Bond Index that leads you more toward Treasury debt and less so towards corporate debt. Now, if you are just starting out with the corporate universe, you are going to overweight the more heavily indebted issuers and those may be issuers that have lower credit quality or may be less likely to pay back their debt. So, there is an argument to be made for potentially adopting a different approach.

So, there's a few different funds out there that try to do this, one of which is the SPDR Barclays Issuer Scored Bond ETF, ticker is CBND. And what that does is it basically looks at bonds based on the return on assets, their interest coverage ratios and their current ratios and it tries to tilt toward issues that score better on those metrics relative to their sector peers as a way of kind of reweighting the portfolio, preventing it from loading up on the riskier issuers.

The funny thing is though, despite all that additional complexity in the approach the yield is actually pretty comparable to the Vanguard Intermediate-Term Corporate Bond ETF, which is just a market-cap-weighted ETF that targets corporate bonds on the intermediate term part of the spectrum. So, this more complex approach isn't necessarily giving you a better outcome, but it's kind of trying to address that concern that I mentioned about the market cap, some of the drawbacks of market capitalization.

There's another fund out there that tries to do something similar called the Wisdom Tree Fundamental U.S. Corporate Bond Index. That basically ranks different bond issuers based on return on invested capital, free cash flow to debt and debt to total assets and then filters out the bottom 20% on those metrics. But similar to the previous fund that I mentioned, it doesn't necessarily give you a better yield or better risk characteristics than a market-cap-weighted fund like the Vanguard Intermediate-Term Corporate Bond ETF. So, I think these are interesting approaches that are trying to tackle this problem. But in terms of the risk/reward trade-off, I don't necessarily think you are getting a better outcome here.

Benz: So, at the end of the day when you survey all of these funds and compare them to their capitalization-weighted alternatives, where do you come out on this question for investors who are using ETFs to be the core of their portfolios. How should they approach the fixed-income space?

Bryan: I think it's important to remember that there is no free lunch in bond investing. Any time you're getting an additional yield or an additional return pickup, you're typically taking on more risk in some shape or form. In most cases, you are taking more credit risk or more interest-rate risk, and those things may not always be apparent. But typically, high yields are good indications that you are taking more risk. So, I think in many cases investors can actually achieve the same outcomes that many of these alternatively weighted funds that offer higher yields offer by simply using market-cap-weighted funds that take more credit risk or that take more interest rate-risk. Now, Vanguard offers a lot of these funds that target certain segments of the market and then weight the portfolios based on market capitalization.

The benefit of retaining a market-cap-weighted approach is, again, it can be cheaper from an implementation standpoint. It tilts the portfolio to the more liquid bonds that tend to be cheaper to trade and they usually carry a little bit lower expense ratios than some of these alternatively weighted funds.

That said, there is one alternatively weighted fund that I do really like and that's the Wisdom Tree Barclays U.S. Aggregate Bond Enhanced Yield Fund, AGGY, that I mentioned earlier. I like that because it's priced like a market-cap-weighted bond index fund at 12 basis points and while it is taking more credit risk than the Barclays Agg, it's still restricting its holdings to the bonds that are in the Agg so you are not getting outside the core bond space. So, I think from that perspective, it can be useful. But again, investors need to be mindful that any time you're getting a yield pickup, you're taking more risk, and you shouldn't take more risk than you can handle.

Benz: Alex, a rapidly evolving part of the ETF market. Thank you for being here with us to discuss it.

Bryan: Thank you for having me.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.