Owning Big Debtors Doesn't Mean More Risk for These Bond ETFs

Market-value-weighted corporate-bond index funds are naturally biased toward the largest debt issuers. It may seem intuitive to conclude that the largest debtors are the riskiest, which has led to the idea that these index funds are poor investments. This notion is inaccurate, particularly in the investment-grade realm. The largest issuers tend to be large enterprises with the cash flow necessary to support their debt. They are not necessarily more leveraged or riskier than smaller issuers. The bond origination process, which takes investor demand into consideration, also helps prevent companies from issuing too much debt.

From 2007 to 2017, the largest 10 U.S. corporate issuers' median leverage, as measured by debt/EBITDA, was on par with the median leverage of all publicly traded U.S. issuers, according to estimates by Goldman Sachs. The median leverage ratio for the largest 10 issuers hovered slightly below 3.0 times, and the corresponding figure for all publicly traded issuers was slightly above 2.5 times.

The leverage ratio figures illustrate that the total market value of outstanding debt must be analyzed in context. Just because a company is an active debt issuer, it doesn't necessarily make it riskier. For example,

CVS Health's debt loads are large by any measure. But its debt is backed by $184 billion of revenue with a 3% net profit margin as of 2017. In other words, large investment-grade debtors are usually large corporations with adequate resources (revenue and cash flow) to service their obligations.

The Underwriting Process for Bond Offerings CVS Health's ability to issue a lot of debt signals healthy demand from market participants. Bond offerings are typically underwritten by a syndicate of investment banks. During the offering, the investment banks distribute the securities to professional buyers, including asset-management and insurance firms. Because the investment banks are taking on the risk of distribution, they must make sure that there is enough demand for the offering. So, they engage with potential buyers to gauge if there is an appetite, and if so, at what terms. If professional buyers do not trust that a company can service its debt, and investment banks do not believe they can distribute a security, then there is no bond offering. That company must then pursue other avenues to raise capital. Given the success of past offerings, there is considerable demand for CVS Health bonds, which in turn signals the market's confidence in the company's financial strength.

While financial health can deteriorate after bonds are first issued, even the lowest-quality investment-grade bonds have low risk of default. And most broad market-value-weighted index funds diversify issuer risk.

Large Debt Issuers Haven't Had High Default Rates

CVS Health is not an outlier. I looked further back and analyzed the fates of LQD's top 10 holdings from 2002 to 2017. Out of the 45 companies that had debt issues among LQD's top 10 holdings during that span, only two companies (

LQD tended to tilt toward slightly higher-quality debt than most of its peers in the corporate-bond Morningstar Category from 2014 to 2017. This was partially because many actively managed strategies invested in junk bonds. While market-value-weighted corporate-bond funds may not always have a higher-quality orientation than active managers, this data suggests that market-value-weighting doesn't necessarily lead to a bias toward lower-quality issuers.

The Final Word Bond indexes constructed through a market-value-weighted methodology are skewed toward the largest debtors. However, this bias doesn't necessarily make the market-value-weighted bond index ETF strategies riskier. This is because large debtors tend to have large revenues to service their obligations. The supply-and-demand dynamic of the debt market also generally does a good job of preventing companies from issuing too much debt.

Market-value-weighting is a simple and elegant approach that mitigates transaction costs by tilting toward the most-liquid issues and keeping turnover low. More importantly, it harnesses the market's collective view about the value of each security for very low fees, which should allow index investors to come out ahead.

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