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Size Doesn't Always Mean Risk With Bond ETFs

ETF Professor

Most equity-based exchange traded funds components are weighed by market capitalization, meaning the largest company in the fund's underlying index takes on the biggest weight in the ETF. For example, Apple Inc. (NASDAQ: AAPL) is the largest holding in S&P 500 and technology sector ETFs by virtue of being the largest U.S. company by market value.

Many of the largest ETFs are cap-weighted funds, something investors don't seem to mind when it comes to equity funds, but with corporate bonds, some investors associate large issue size with increased risk.

The iShares iBoxx $ Investment Grade Corporate Bond ETF (NYSE: LQD), the largest corporate bond ETF, follows the Markit iBoxx USD Liquid Investment Grade Index and uses a strategy akin to cap weighting with equities, but that doesn't mean LQD is a “risky” ETF. Actually, the opposite is true.

Weighting By Issue Size

In many traditional bond ETFs, including LQD, individual weights are determined by a bond issue's principal amount outstanding multiplied by the bond price. That's similar to determining a stock's market value by multiplying shares outstanding by current price.

“It’s true that issuers with larger debt size have larger representation in the index,” said BlackRock in a recent note. “That makes sense: They represent more of the market and the investable opportunity set. But it doesn’t necessarily follow that their large debt issuance makes the index or any individual issuer more risky. Size does not equal risk.”

In the case of LQD, the ETF holds nearly 1,850 bonds, none of which account for more than 3 percent of the ETF's weight. LQD's top 10 holdings include issues from JPMorgan Chase & Co. (NYSE: JPM), AT&T Inc. (NYSE: T) and Apple. Ratings on LQD's top 10 holdings range from BBB+ to AAA, proving the point that size does not equal risk with bonds.

Points To Consider

“Higher quality issuers that are able to tap the debt markets in scale generally do so because the soundness of their balance sheet allows it,” said BlackRock. “These issuers may be awash with cash, have low leverage or a rich portfolio of intellectual property or other earning assets. Larger debt issuance typically comes with a larger pool of assets and equity market values.”

Data suggest investors like the way LQD does business. The fund has added $10.8 billion in new assets this year, making it 2017's top asset-gathering fixed income ETF.

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