Bond ETFs Track Smart-Beta Indices, Too

ETF Trends

The new wave of smart-beta indexing methodologies is not limited to stock exchange traded funds. Some bond ETFs follow alternatively weighted indices as well.

The largest and most popular corporate bond ETFs typically track a traditional market-capitalization-weighted index that focus on the most indebted issuers.

“Skewing toward the most-indebted issuers may be particularly problematic in the high-yield bond market because these issuers may carry greater default risk than their less indebted counterparts,” according to Morningstar analyst Alex Bryan. “The biggest debtors may also be more likely to suffer a credit-rating downgrade, which could hurt performance.”

On the other hand, investors can consider alternative index-based bond ETFs, such as the PowerShares Fundamental High Yield Corporate Bond ETF (PHB) . PHB tries to reflect the performance of the RAFI Bonds US High Yield 1-10 Index, which selects debt securities based on fundamentals such as the company’s size, sales, cash flow, dividends and book value of assets.

Consequently, the fundamental indexing methodology could diminish the ETF’s exposure to the most heavily indebted companies while other high-yield bond ETFs would weight holdings by market value.

However, the alternative indexing methodology could steer a fund toward less liquid debt in the fixed-income markets, potentially raising the cost of managing the portfolio. Consequently, PHB limits holdings to issues with at least $350 million in par value outstanding.

Additionally, PHB excludes some of the junkiest debt, compared to other junk-bond ETFs in the space. The ETF’s credit quality breakdown includes BBB 10%, BB 63% and B 26%. In contrast, the iShares iBoxx $ High Yield Corporate Bond ETF (HYG) includes BBB 5.0%, BB 49.9%, B 29.8%, below B 11.8% and not-rated 3.5%. [Indexology®: High Yield Bonds: Can more juice get squeezed out of the junk bond sector?]

“This exclusion may help improve the fund’s risk-adjusted performance,” Bryan said. “Investors reaching for yield may be tempted to tilt toward the lowest-grade bonds and, in their quest for income, push the prices of these bonds above their fair values.”

Over the past 10-years, BB-rated debt provided better risk-adjusted returns, compared to investment-grade and lower-quality debt securities.

PHB also comes with a 3.24% 30-day SEC yield. High-yield, junk bond yields over benchmark Treasuries have been pushed down as investors piled back into fixed-income options this year. The tighter credit spread reflects the improving confidence investors have in riskier debt in an expanding economy. According to the S&P, the default rate on U.S. speculative-grade debt was 2.1% in 2013, compared to the 4.3% historical average. [Bond ETFs Beloved in 2014]

“This sensitivity to the business cycle causes high-yield bonds to behave more like equities than investment-grade bonds,” Bryan added.

For more information on the fixed-income market, visit our bond ETFs category.

Max Chen contributed to this article.

Full disclosure: Tom Lydon’s clients own shares of HYG.

The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.

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