Cheap Corporate Bond ETF for Everyday Investors

The U.S. corporate-bond market is a deep sea with nearly $9 trillion outstanding at the end of 2017. While savvy investors with vast resources certainly have better chances of catching winners, bond investing can be a daunting task for everyday investors. Luckily, it’s easy to follow the market’s collective wisdom with a low-cost portfolio like

The fund tracks the Bloomberg Barclays US 5-10 Year Corporate Bond Index, which provides market-value-weighted exposure to U.S. investment-grade corporate bonds with between five and 10 years until maturity. This fund is one of the lowest-cost options in the corporate-bond Morningstar Category, and it has a strong index-tracking record. But its market-value-weighting approach leads to heavy exposure to financial-services bonds.

Roughly one third of the portfolio is invested in the financials sector, which is a source of risk. Its average sector exposure has been less than a fourth of the portfolio from 2010 to 2016, but the stake gradually grew to be more than 30% of the fund by the end of 2017. Any negative developments in this sector could hurt the fund’s performance. This concentration is mostly driven by large U.S. banks. Since 2010, they issued a record amount of debt to take advantage of low rates and meet the strict postcrisis capital requirements. Consequently, market-value-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.

The duration of the fund is in line with its category peers. As of June 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 index management has kept the fund close to its index. From July 2013 to June 2018, the fund produced an annualized return of 3.5%, lagging its benchmark by 10 basis points. This gap is a hair more than with its 7-basis-point expense ratio, which is lower than over 90% of its category peers. Over the trailing five years through June 2018, the fund’s return and risk-adjusted performance were on par with the category average. That said, its low fee should give it an edge going forward.

Fundamental View Investing in a market-cap-weighted bond index, like with stock indexing, has advantages. For a low fee, the indexed portfolio replicates the composition of the fixed-income market and reflects 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 return potential. 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 have already issued more than $130 billion of debt between Jan. 1 and March 15, 2018 according to JP Morgan. The issuances were largely driven by low rates and postcrisis regulatory changes.

Accordingly, the portfolio is biased toward the financial-services sector, which accounted for more than 33% of the portfolio, as of June 2018. This single-sector concentration makes the fund vulnerable to sector-specific risk. Its category peers typically allocate about a 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 both driven by the U.S. banks and the recent surge in mergers-and-acquisitions-related debt issuances by telecommunication firms. Its typical category peer invests roughly three fourths of its assets in A and BBB rated bonds, dividing the balance between higher-credit-quality and below-investment-grade securities. However, this fund does not invest in high-yield securities.

While the fund’s sector and credit-rating distribution differs from the category average, its duration-risk profile is similar to the corporate-bond category average. As of June 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 five-year annualized return through June 2018 of 3.5% matched the category average. The portfolio’s low fee helped it produce the competitive return against its peers that dabble in higher-yielding junk bonds.

Portfolio Construction The fund earns a Positive Process Pillar rating because it accurately captures its target investment universe, which is sensible and investable at a low cost. It effectively harnesses the market's collective wisdom about the relative value of each bond and tilts toward the most liquid securities, which mitigates transaction costs.

The fund employs a sampling approach designed to track the performance of the market-value-weighted Bloomberg Barclays US 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 $300 million. It holds a range of securities that, in the 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/Costs This fund receives a Positive Price rating because of its cost advantage over its category peers. It charges 7 basis points compared with the category median fee of 0.65%. In fact, the fund is cheaper than 90% of its peers. From its inception in November 2009 through June 2018, the fund lagged its benchmark by 10 basis points annually, slightly more than the amount of its fee.

Alternatives

Silver-rated

IShares Intermediate Credit Bond CIU (expense ratio: 0.06%) is also a good index alternative. This Bronze-rated fund offers market-value-weighted exposure to the intermediate-term credit market. Unlike its category peers, it invests in sovereign and supranational debt securities. This fund focuses on investment-grade issues and takes less duration risk than the category average. It had a duration of 4.2 years as of June 2018. This fund will switch to a new benchmark between August and October 2018 that will include only investment-grade corporate bonds with between five and 10 years remaining until maturity. At that time, it will also change its ticker to IGIB from CIU.

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