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ETFs

New Index, Lower Fee Boost This Corporate-Bond ETF

This fund is a great option for investors seeking exposure to intermediate-term corporate bonds.

Following a mid-2018 makeover that left it with a much lower fee and a new benchmark, there is more to like about

Since Aug. 1, 2018, the fund has tracked the ICE BofAML 5-10 Year U.S. Corporate Index. The index is a gauge of the performance of U.S.-dollar-denominated investment-grade corporate bonds that have maturities ranging from five to 10 years. Qualifying bonds are weighted by market value, which tilts the portfolio toward the largest issues in the market, which tend to be easy to obtain and cheap to trade. The fund’s new bogy is cleaner (it excludes supranationals, municipal bonds, and sovereign debt, which were included in its predecessor) and more modular (when considered in the context of its similarly recast sibling exchange-traded funds) than its prior one.

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 nearly 2,000 bonds. That said, the fund does have considerable exposure to the banking sector, which represents just more than 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. Just over 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.

Given its relatively longer duration, the fund’s new benchmark will be more sensitive to changes in interest rates than its former one and thus incrementally more volatile. From January 1977 through September 2018, the fund’s new index outpaced the corporate-bond Morningstar Category average and the Bloomberg Barclays Corporate Bond Index by 55 and 36 basis points annualized, respectively.

Fundamental View Investment-grade corporate-bond returns are primarily driven by interest rates because their default risk is low. But because they do 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 because 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 is 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 perverse. 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) assessment 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. 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. That said, the market still reacts to credit-rating changes, suggesting that these ratings can exert some influence on perceptions of risk. In any case, 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.

Portfolio Construction This market-cap-weighted portfolio free-rides on the market's collective wisdom and keeps transaction costs low by favoring the largest issues in the market. The inherent efficiencies of the fund's index, the makeup of its bogy, and the strong index-tracking capabilities of the team backing it support this fund's Positive Process Pillar rating. The fund employs representative sampling to track the ICE BofAML 5-10 Year U.S. Corporate Index, which includes investment-grade, fixed-rate corporate bonds denominated in U.S. dollars with between five and 10 years until maturity. Qualifying issuances must have a face value of at least $250 million, which makes the index easier to track and helps mitigate transaction costs. Bonds that make the cut are weighted by market value. This tilts the portfolio toward the largest issuances but limits exposure to issuer-specific risk. The index is rebalanced monthly.

Fees BlackRock charges a 0.06% expense ratio for this fund, which is the lowest among its closest peers. This low fee gives the fund a durable edge, supporting a Positive Price Pillar rating.

Alternatives Vanguard Intermediate-Term Corporate Bond ETF VCIT (0.07% expense ratio) offers comparable exposure to IGIB at a marginally higher cost. It tracks the Bloomberg Barclays U.S. 5–10 Year Corporate Bond Index, which targets investment-grade bonds with between five and 10 years remaining until maturity. The fund's duration-risk profile is on par with the category norm. Its cost advantage and index-tracking capability underpin its Analyst Rating of Silver.

PIMCO Investment Grade Credit Bond PIGIX is a compelling actively managed alternative. The combination of its experienced manager backed by significant analyst resources and consistent strong performance has earned this fund a Silver rating. It charges a 0.59% fee, and its duration was 6.3 years as of September 2018. Its 10-year annualized return through September 2018 was 7.9%, placing the strategy in the category’s top decile.

Disclosure: Morningstar, Inc. licenses indexes to financial institutions as the tracking indexes for investable products, such as exchange-traded funds, sponsored by the financial institution. The license fee for such use is paid by the sponsoring financial institution based mainly on the total assets of the investable product. Please click here for a list of investable products that track or have tracked a Morningstar index. Neither Morningstar, Inc. nor its investment management division markets, sells, or makes any representations regarding the advisability of investing in any investable product that tracks a Morningstar index.

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