Corporate Credit Spreads on the Rise

Along with the rise in uncertainty and market volatility, the risk premiums in corporate bonds have also increased. The predominant concern for the bond market lately has been focused on the potential timing and magnitude of a change in policy from the Federal Reserve regarding interest rates. Indeed, since U.S. Treasuries are essentially risk-free (absence of credit risk), interest-rate risk is the primary issue. On the other hand, corporate bonds are exposed to credit risk, which is reflected in the yield premium they offer over Treasuries of comparable duration.

Like Treasuries, corporate bonds also court interest-rate risk. But that sensitivity to interest rates can be somewhat offset by credit risk. The higher premiums offered by corporate bonds can counterbalance price declines associated with rising interest rates. That said, yield-starved investors helped drive risk premiums to levels that didn't seem to fairly compensate for the risks being assumed. Recently, however, credit spreads have widened considerably since touching post-crisis lows in the summer of last year.

Using history as our guide, we can put current credit spreads in context. Based on the option-adjusted credit spread of the Bank of America Merrill Lynch U.S. Corporate Bond Index over U.S. Treasuries, investment-grade corporate bonds currently have a credit spread of 172 basis points (a 65-basis-point rebound over the past year). Its historical average since 1997 (the earliest the data is available) is 121 basis points, with all-time highs and lows of 656 and 53 basis points, respectively.

High-yield, or "junk," bonds are issued by lower-quality companies, but they also provide juicier coupons to compensate for their higher credit risk. Based on the option-adjusted credit spread of the Bank of America Merrill Lynch U.S. High Yield Index over U.S. Treasuries, high-yield corporate bonds currently have a credit spread of 591 basis points (a 255-basis-point rebound over the past year). Its historical average since 1997 (the earliest the data is available) is 579 basis points, with all-time highs and lows of 2,182 (peak of 2008 credit crisis) and 241 basis points, respectively.

With that as the backdrop, we spotlight an investment-grade bond exchange-traded fund that has relatively limited interest-rate risk. A key difference between

Suitability This ETF offers diversified exposure to investment-grade corporate bonds with maturities ranging from one to 10 years. The fund can be a suitable satellite holding for investors who want fixed-income exposure with low credit risk but a higher yield than government bonds of similar duration. Tactical investors could use this fund opportunistically when they feel corporate bonds are inexpensive relative to Treasuries.

As of the end of August, the fund's yield to maturity (2.8%) was above its trailing three-year average (2.4%). With the five-year Treasury currently yielding 1.63%, the fund offers investors decent compensation for the increased risk that corporate bonds introduce. For context, the yield spread between the fund and five-year Treasuries has averaged 0.86% over the trailing three-year period. The current risk premium is higher than its trailing three-year average, which suggests that new investors would be fairly compensated for the additional credit risk.

For investors comfortable with the increased risk of below-investment-grade debt, junk-bond funds with comparable duration are yielding close to 7%. Those who are undeterred by the heightened credit risk posed by lower-quality borrowers may find the additional yield offered by junk bonds appealing. That said, more risk-averse investors would likely prefer sticking with an investment-grade corporate-bond ETF like ITR, thereby avoiding the higher volatility that comes with junk bonds.

The fund's holdings carry an average credit rating of A and a modified adjusted duration of 4.4 years. Thanks to their higher yields, corporate bonds generally have shorter duration than Treasury bonds of similar maturity, which means that they tend to be less sensitive to changes in interest rates. In any case, it's important to keep the fund's interest-rate risk in perspective, as over time the fund will reconstitute and rebalance into higher-yielding bonds. Given the fund's exposure to credit risk, widening credit spreads would likely weigh on the fund's performance, and vice versa.

Fundamental View During the past several years, credit spreads and yields of intermediate-term U.S. corporate debt compressed to near all-time lows. However, after bottoming in June 2014, corporate-credit spreads have begun to increase. As of Aug. 26, 2015, the option-adjusted credit spread between the Bank of America Merrill Lynch U.S. Corporate 3-5 Year Index and U.S. Treasuries was 131 basis points, which is a touch higher than precrisis levels and 55 basis points wider than the low it reached in the summer of 2014.

Corporate bonds carry more credit and liquidity risk than U.S. Treasuries. But U.S. companies are currently in good shape as they have fortified their balance sheets in recent years and currently have ample cash. The last time an investment-grade-rated company defaulted was 2011, and the average default rate since 1981 for investment-grade debt is 0.11%, according to S&P's 2014 Annual U.S. and Rating Transitions publication. The fund has an average credit rating of A, which has a historic default rate average of just 0.10%, according to that report. With a current yield to maturity of 2.84%, the fund's expected yield, net of expense fees and losses from default, is about 2.6%.

Financial-services firms, which issued bonds representing approximately 37% of the fund's assets, have also strengthened their balance sheets in order to comply with the Basel III and Dodd-Frank regulations. The St. Louis Fed Financial Stress Index, which measures the degree of stress in the financial markets, is at one of its lowest levels ever, suggesting that financial-market conditions are relatively strong.

Industrial firms, which issued bonds representing about 58% of the fund, can be especially sensitive to the business cycle. The private sector of the U.S. economy has improved since 2009, but growth rates have decelerated recently. Moreover, although profit margins are near a 15-year peak, they could face a mild headwind from rising employment costs as wages inch higher and more people join the workforce. A strong U.S. dollar also presents a headwind for many firms' foreign operations. Other concerns, from the perspective of bond investors, include rising merger-and-acquisition activity and increasing corporate leverage. Acquisitions can deplete balance sheets of cash and often result in greater leverage for the acquisitor. After retrenching in the wake of the 2008 credit crisis, corporate leverage ratios have started to move higher as growth in new debt issuance has outpaced earnings growth during the past few years.

On the other hand, household debt, as measured by debt service payments as a percentage of disposable personal income, has declined during the past few years. As recently as the fourth quarter of 2007, that ratio stood at 13.2%, whereas as of the first quarter of 2015 it had fallen below 10%. Further, personal spending has increased steadily, while the unemployment rate has fallen to the lowest level since 2007. Improving financial health for consumers is an important trend to monitor given consumer spending represents about 70% of the domestic economy. Portfolio Construction The fund tracks the Barclays Intermediate U.S. Corporate Bond Index, which measures investment-grade, U.S. dollar-denominated, fixed-rate, taxable-corporate-bonds with maturities ranging from one to 10 years. For inclusion, bonds must have at least $250 million in par value outstanding. About 30% of the benchmark is made up of bonds with maturities of one to three years; bonds with three- to five-year maturities make up 46%, and the remaining 24% is made up of bonds with maturities of seven to 10 years. It includes dollar-denominated securities publicly issued by financial (37%), industrial (58%), and utilities (5.5%) issuers that trade on a U.S. exchange. The index weights its holdings by market capitalization and rebalances at the end of each month. In terms of credit quality, BBB rated bonds make up the largest chunk of the portfolio with about 46% of total assets, followed by A (44%), AA (9%), and AAA (1%) bonds. The fund currently has a modified adjusted duration of 4.4 years and a yield to maturity of 2.8%. Distributions are paid monthly. Fees The fund has an expense ratio of 0.12%, which compares favorably to both the ETF and open-end corporate-bond category averages of 0.19% and 0.87%, respectively. The fund has done relatively well managing its tracking error. Over the trailing five-, three-, and one-year periods through July 2015 the fund has lagged its benchmark by 0.31%, 0.20%, and 0.16%, respectively. ITR has been able to more closely replicate its benchmark as its assets have grown and it has moved closer to full replication.

Alternatives The largest and most liquid corporate bond ETF is LQD. It has a longer duration of around eight years and a similar fee of 0.15%. Vanguard Intermediate-Term Corporate Bond ETF VCIT is also a reasonable alternative. It also has a longer duration (6.4 years) than ITR but not quite as long as iShares' LQD. Vanguard's VCIT charges the same fee (0.12% expense ratio) as ITR. As of the end of August, LQD and VCIT were sporting yields to maturity of 3.6% and 3.5%, respectively. The Vanguard ETF offers a nearly identical yield as LQD despite its relatively shorter duration.

Investors looking for longer duration and a mix of corporate and noncorporate bonds might consider the

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