Broad investment-grade bond index funds sometimes get a bad rap for their bias toward Treasuries and agency mortgage-backed securities, which limits their yield. But it isn't necessary to hire an active manager to take more credit risk within the investment-grade arena. Investors can accomplish that more cheaply by buying an investment-grade corporate-bond index fund like iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD).
There is a lot to like about this fund, from its durable cost advantage to its broadly diversified market-cap-weighted portfolio that approximates the composition of the U.S.-dollar investment-grade corporate-bond market. However, the fund's exclusion of bonds with less than three years until maturity gives it more interest-rate risk than most of its peers and prevents it from fully representing the opportunity set. It warrants a Morningstar Analyst Rating of Bronze.
The fund tracks the Markit iBoxx USD Liquid Investment Grade Index, which includes liquidity-screened U.S.-dollar-denominated investment-grade corporate debt with at least three years until maturity. This three-year cutoff excludes a sizable chunk of the corporate-bond market, keeping the fund focused on intermediate- and long-term bonds. Qualifying bonds are weighted by market value, which tilts the portfolio toward the largest issues in the market that tend to be easy to obtain and cheap to trade.
This portfolio relies on the market's collective wisdom and does not attempt to avoid bad credit risks or identify undervalued bonds. Its broad reach effectively diversifies issuer-specific risk, sweeping in more than 1,000 bonds. That said, the fund does have considerable exposure to the banking sector, which represents just over a fourth of the portfolio. Reflecting the composition of the market, the fund tilts toward bonds at the lower end of the investment-grade credit spectrum. Nearly 90% of the portfolio is invested in bonds rated A and BBB, so it does have a fair bit of exposure to spread risk. But like most investment-grade funds, interest-rate risk is the primary driver of the fund's returns.
Performance here hasn't stood out from the pack over the trailing 10 years through August 2018. During that time, it nearly matched the corporate-bond Morningstar Category average and the Bloomberg Barclays U.S. Corporate Bond Index, which casts a wider net and includes more short-term bonds. However, the fund's low fee should give it an edge over the long term.
Investment-grade corporate-bond returns are primarily driven by interest rates, since their default risk is low. But since they introduce credit risk, they offer higher expected returns than Treasury bonds with comparable interest-rate risk. This difference is the credit spread. When credit spreads widen and the market requires greater compensation for bearing credit risk, which often happens in weakening business environments, investment-grade corporate bonds tend to underperform safer Treasuries. Conversely, narrowing credit spreads give lower-quality bonds a boost. The lower the bond's credit quality, the more sensitive it is to changes in the credit spread. This fund has some spread risk since it has considerable exposure to bonds at the lower end of the investment-grade credit spectrum.
This broad market-value-weighted portfolio relies on the market's collective wisdom to assess the relative value of its holdings, effectively betting that the market is offering a fair deal. In aggregate, that's probably a good assumption. The market knows what investment-grade bonds' future cash flows will be with greater certainty than stocks', meaning there is less room to find an informational edge here. Bonds' risk and return are closely linked. So, while it may be easy to construct a bond portfolio that will produce market-beating returns, it is hard to do so without taking greater risk.
There are some criticisms of market-value-weighted bond index funds, like this one, but they do not shake our confidence in this approach. Most notably, the idea of assigning larger weightings to more heavily indebted issuers seems a bit illogical. But larger issuers tend to be larger companies with the resources necessary to effectively service their debt. And to the extent that these larger issuers are riskier, they should offer compensation for that risk.
This type of bond index fund could also be criticized on the grounds that the market is overly reliant on the credit rating agencies' (Moody's, S&P, and Fitch) assessments of credit risk, and these agencies may be slow to pick up changes in credit quality, which could create some mispricing. There's probably only a little credence to this view. While ratings agencies' risk assessments have an impact on market prices, yields tend to change ahead of credit-rating changes, which suggests that the market doesn't wait for the agencies to change their ratings to recognize the change in risk. Overall, there probably isn't much mispricing in the investment-grade bond arena.
The fund's cost advantage is its greatest appeal. It builds on its expense ratio advantage by mitigating transaction costs through its weighting approach, which favors the most-liquid bonds in the market that tend to be the cheapest to trade. The fund also applies minimum liquidity requirements, which further reduces transaction costs and makes the index easier to track.
This broad market-value-weighted portfolio free-rides on active investors' collective wisdom and keeps transaction costs low by favoring the largest issues in the market. But its exclusion of bonds with fewer than three years remaining until maturity prevents it from fully representing the investment-grade corporate-bond opportunity set, so it earns a Neutral Process Pillar rating.
The fund employs representative sampling to track the Markit iBoxx USD Liquid Investment Grade Index, which includes investment-grade, fixed-rate corporate bonds denominated in U.S. dollars with at least three years until maturity. To mitigate turnover, bonds must have at least three and a half years remaining to maturity to be added to the index, but they can stay in as long as they have at least three years until maturity. Qualifying issues must have a face value of at least $750 million, which makes the index easier to track and helps mitigate transaction costs. Bonds that make the cut are weighted by market value, subject to a 3% issuer cap. This tilts the portfolio toward the largest issues, but limits exposure to issuer-specific risk. The index is rebalanced monthly.
BlackRock charges a 0.15% expense ratio for this fund. While there are cheaper alternatives, this low fee gives the fund a durable edge against most of its peers, supporting a Positive Price Pillar rating. Over the trailing three years through August 2018, the fund lagged its benchmark by 24 basis points annualized, slightly more than the amount of its expense ratio, likely because of transaction costs and sampling error. However, tracking error has been low.
Vanguard Total Corporate Bond ETF (VTC) offers more-comprehensive exposure to the investment-grade corporate-bond market for a lower 0.07% expense ratio. It includes bonds with at least one year to maturity and weights its holdings by market value. This gives it slightly less exposure to interest-rate risk than LQD. BlackRock also offers a lower-cost and more comprehensive portfolio in iShares Broad USD Investment Grade Corporate Bond ETF (USIG) (0.06% expense ratio), which provides similar exposure to VTC.
Goldman Sachs Access Investment Grade Corporate Bond ETF (GIGB) (0.14% expense ratio) offers similar exposure to the broad U.S.-dollar investment-grade market, but it attempts to avoid the lowest-quality issuers. It ranks all issuers in each sector based on the year-over-year change in their profit (measured by EBIT) margin and leverage and excludes the bottom ranking 10%. Bonds that make the cut are weighted by market value. This approach should slightly reduce risk. It isn't clear that there is a significant benefit to this approach. That said, this fund enjoys a cost advantage compared with LQD.
IShares Edge Investment Grade Enhanced Bond ETF (IGEB) (0.18% expense ratio) applies a stricter screen for quality, eliminating the 20% of issuers with the highest estimated probability of default from each credit-rating bucket. The fund's model uses an optimizer that attempts to build a portfolio with the highest default-adjusted spread, under a set of constraints. Its dual focus on value and quality should help it boost returns, while keeping risk in check.
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Alex Bryan, CFA does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.