Innovation continues to be a defining characteristic of the quickly-growing fixed income ETF space as evidenced by the launch of the SPDR Barclays Capital Issuer Scored Corporate Bond ETF (NYSEARCA:CBND) on Thursday by State Street. The new ETF will seek to replicate the performance of the Barclays Capital Issuer Scored Corporate Index, a benchmark that includes U.S. dollar denominated corporate issues that are rated investment grade (Baa3/BBB- or higher) by at least two of the big three ratings agencies.
CBND will be unique from existing products in the Corporate Bonds ETFdb Category because of the manner in which the underlying index is constructed. That methodology involves both determining the weightings attributed first to individual issuers and then to security weights. Individual issuers in the related benchmark are weighted based on three fundamental financial ratios (only debt issued by companies with publicly-traded stock are eligible for inclusion). Those ratios include:
- Return on Assets: Equal to net income divided by total assets
- Interest Coverage: Equal to EBIT (earnings before interest and taxes) divided by interest expense
- Current Ratio: Current assets divided by current liabilities
By determining the allocation to individual issuers based on these factors, CBND’s holdings will be tilted away from companies that are losing money (i.e., those with negative net income or EBIT) and toward debt issuers with solid balance sheets and cash flows. Since all of the metrics considered are determined as percentages of a balance sheet or income statement item, size of the firm won’t be a determining factor. The largest individual securities in the portfolio at launch included debt issued by HSBC (HBC), Walgreens (WAG), Deutsche Telekom (OTCQX:DTEGY) and Altria Group (NYSE:MO).
Individual security weights are then calculated by the relative market value of each eligible security issued by the issuer. At the end of February, there were about 3,500 securities in the underlying portfolio and the modified adjusted duration of the index was slightly greater than six years.
CBND is the 22nd ETF in the Corporate Bonds ETFdb Category, a lineup of products that has aggregate assets in excess of $25 billion. The largest of those ETFs is the iShares iBoxx $ Investment Grade Corporate Bond Fund (NYSEARCA:LQD), which seeks to replicate an index comprised of about 750 investment grade corporate bonds. LQD charges an expense ratio of just 15 basis points, a metric CBND (0.16%) will come close to matching.
CBND will offer exposure that is generally similar to LQD and other corporate bond ETFs, but will use an entirely different methodology for selecting holdings. Instead of selecting the largest outstanding debt issues - as many bond funds do - CBND will pick the issuers with the strongest scores on the financial ratios listed above. That should result in a portfolio comprised of higher quality issuers, meaning a lower chance of default.
Fundamental Bond ETFs
CNBD becomes only the second U.S.-listed ETF to replicate an index constructed using fundamental factors, joining the PowerShares High Yield Corporate Bond Fund (NYSEARCA:PHB). That ETF offers exposure to bonds with credit ratings below investment grade, but determines components and security weightings not on the size of the debt issue but by certain fundamental measures. The metrics used to construct the index underlying PHB are different from those used in CBND’s benchmark, and include book value of assets, gross sales, gross dividends, and cash flow - each based on five-year averages. The result is a junk bond ETF that includes debt of companies with stronger cash flow and credit quality than the broader universe of high yield debt issuers.
In a recent interview with ETFdb, the founder of the firm behind a number of fundamental indexes offered some insights on the impact that weighting methodology can have on bond ETF performance. “When you think about capitalization weighting in stocks the drawbacks are fairly evident,” said Rob Arnott. “When you talk about cap weighting in bonds, the drawbacks are flagrantly obvious.”
Disclosure: No positions at time of writing.
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