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ETF Specialist

Better Bond ETFs?

A new crop of rules-based bond ETFs is attempting to improve on traditional market-cap-weighted alternatives.

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A version of this article was published in the June 2016 issue of Morningstar ETFInvestor. Download a complimentary copy of ETFInvestor here.

There's a lot to like about market-cap-weighted bond index funds. They offer low fees, a consistent and transparent approach with no key-manager risk, and low transaction costs because they favor the most-liquid issues and have fairly low turnover. But market-cap weighting may not be the optimal way to construct a bond portfolio because it tilts toward the most heavily indebted issuers. The implications of this are different in the investment-grade and high-yield market segments. In the investment-grade market, cap-weighting skews most portfolios toward low-yielding Treasuries and agency mortgage-backed securities, dragging down expected returns. In the high-yield market, the biggest debtors may have particularly high credit risk.

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

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