What Are They?
- Corporate bond ETFs provide exposure to a specific section of the corporate bond market by tracking an index with a fixed duration. These indexes contain bonds with various maturity dates, managed so that the entire index has a fixed average maturity. If projected interest rates rise, the price of a corporate bond ETF falls.
- Corporate bond ETFs come in two varieties: Lower-yielding Investment-Grade bond funds and higher-yielding 'Junk' (High-Yield) bond funds. Investment-Grade bond ETFs are divided by average maturity in years with long-term funds holding corporate bonds with a duration of 10+ years, intermediate-term funds generally holding 3-10 year duration corporate bonds and short-term funds holding anything with a duration of 3 years or less. The specifics of average maturity of a fund's portfolio as well as average bond rating of an ETF's holdings vary according to issuer and individual fund.
Why and How to Use Them
- Corporate bonds are a core component of diversified bond portfolios, as they offer greater returns and risks than government bonds. Due to their high level of interest paid, generally in the form of monthly distributions, corporate bond ETFs may be especially suitable for individuals approaching or already in retirement. However, corporate bonds - especially of the High-Yield variety - are more volatile than Treasuries and other Government-issued bonds and are thus not suitable for everyone (it all boils down to your risk tolerance).
- The High-Yield bond spread is a widely-used gauge to determine the overall health of the credit market. Comparing the difference in yields between 'Junk' bonds and either U.S. Treasuries or Investment-Grade corporate bonds indicates a higher or lower risk of default among the lower-rated issues in the bond universe (a wider spread indicates a higher risk of 'Junk' bonds defaulting). Investors who feel the market has become overly bearish may wish to shift into higher-yielding bond ETFs as they feel the market is overestimating the chance these bonds will default relative to the yield offered.
What to Look Out For
- As an alternative to Investment-Grade bond ETFs, consider U.S. government bond ETFs. They offer lower yields but an even greater degree of safety than Investment-Grade funds.
- As a general rule, Investment-Grade bond ETFs have considerably lower expense ratios (ER) than their High-Yield cousins. A brief comparison done at press time showed the iShares iBoxx $ Invest Grade Corp Bond Fund (NYSEARCA:LQD) sported an ER of just 0.15%. The SPDR Barclays Capital Long Term Credit Bond ETF (NYSEARCA:LWC) also had an ER of 15 basis points. This compares to an ER of 0.50% for the iShares iBoxx $ High Yield Corporate Bond Fund (NYSEARCA:HYG) and an ER of 40 basis points for the SPDR Barclays Capital High Yield Bond (NYSEARCA:JNK). This difference in expenses serves to offset, somewhat, the higher yields offered by 'Junk' bond ETFs and is worth bearing in mind when deciding between types of corporate bond ETF for your portfolio.
- For a general treatment of corporate bond investing, see Brad Ferris's An Investor's Guide to Corporate Bonds.
- For a discussion of bond ETF costs and and the tax status of dividends paid, see David Jackson's Are Bond ETFs a Good Deal?
- For an in-depth analysis of long-term stock vs. bond performance, see Rob Arnott's Bonds: Why Bother and Richard Shaw's Stock vs. Bond Performance.
- For a discussion of some of the potential issues with bond indexing, see Matt Hougan's Bond Indexes: Fundamentally Flawed. Larry McDonald warns investors to Use the Right Yield Data for Bond ETFs. Kurt Brouwer points out that Bond ETFs Suffer from Pricing Discrepancies.
- For more on bonds and portfolio planning for retirement, see Chance Carson's High Yielding Retirement Strategy Utilizing Bond ETFs.
This page is part of The Seeking Alpha ETF Selector which sorts ETFs by type, highlights how to use them and what to look out for, and provides links to articles that discuss key issues for investors.