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Innovation has become a hallmark of the ETF industry in recent years, as new and existing issuers alike have have rolled out increasingly complex and creative products that have further expanded the universe of asset classes and investment strategies available through exchange-traded products. Perhaps no corner of the ETF lineup has grown as quickly as the investment grade corporate bond space. At the beginning of 2009, there were only four ETFs in the Corporate Bonds ETFdb Category with aggregate assets of about $8 billion. As investors have become more comfortable with the combination of fixed income exposure and ETFs, both products and assets have skyrocketed. There are now 23 ETFs in this ETFdb Category with a total of nearly $30 billion in AUM at the end of May.

Much like the rest of the ETF industry, this growth has been marked by innovation, as opposed to duplication. Guggenheim introduced a suite of target maturity date bond ETFs that feature a “yield profile” that more closely resembles individual fixed income securities. Van Eck rolled out product that invests in floating rate corporate debt (NYSEARCA:FLTR). PowerShares (NYSEARCA:PICB) and State Street (NYSEARCA:IBND) have both developed ETFs that invest in corporate debt of ex-U.S. issuers.

But perhaps the biggest breakthrough in the corporate bond arena came earlier this year when State Street introduced its Issuer Scored Corporate Bond ETF (NYSEARCA:CBND), a product that takes a fundamentally different approach to delivering exposure to an asset class that is a core component of many fixed income portfolios.

Fundamental Approach

Adoption of bond ETFs has been relatively slow, in part because investors have only gradually become aware of the potential benefits of ETFs: lower expenses, enhanced transparency, and potentially superior tax efficiencies. But the adoption process has also been slow because of some concerns about the manner in which fixed income exposure and the exchange-traded structure combine.

The indexes to which many fixed income ETFs are linked weren’t necessarily designed as investable assets. The BarCap Aggregate Index that AGG and BND seek to replicate, for example, has some 8,000 individual components, many of which trade irregularly. And most bond ETFs maintain a constant duration across time, maintaining a steady focus on debt with a maturity within a certain window relative to the present.

Another common characteristic is a market capitalization weighting methodology that gives the largest index allocations to the largest issuers of debt. Just as there are potential pitfalls to cap-weighting strategies in index-based equity products–such as the tendency to overweight overvalued stocks and underweight undervalued stocks–building an investable asset on the fixed income side of the portfolio can be less than optimal. A greater debt burden will generally translate into a greater strain on cash flows, which can reduce the creditworthiness of an issuer.

(Incidentally, this feature may also explain the increased interest in corporate bond ETFs in recent years; as the U.S. government’s debt burden has ballooned, the allocation to Treasuries in Total Bond Market ETFs has similarly grown; those seeking more balanced exposure to the investment grade debt market have perhaps felt compelled to complement ETFs such as AGG or BND with additional corporate debt.)

Alternative Strategies

A number of alternatives to cap weighting have popped up on the equity side in recent years, with ETFs offering exposure to equal-weighting, dividend-weighting, revenue-weighting, and multi-factor fundamental weighting all bursting on to the scene (and many of them attracting significant assets).

But the push to unveil alternatives to cap-weighting in fixed income products has unfolded a bit more slowly. Last summer PowerShares switched the focus of an existing junk bond ETF, deciding to have PHB seek to replicate an index based on the RAFI methodology that has become popular in many equity ETFs.

And now State Street has put its own twist on the fundamental weighting game, coming up with an investment grade corporate bond product that takes a unique approach to selecting issuers to be represented.

Fundamental Difference

Instead of giving the largest allocations to the biggest debtors, the index to which CBND is linked uses three fundamental factors to determine the weight given to each issuer among those in the eligible universe:

  • Return on Assets: Net income / total assets
  • Interest Coverage: EBIT (earnings before interest and taxes) / interest expense
  • Current Ratio: Current assets / current liabilities

These ratios will actually favor issuers with more manageable debt burdens, as lower interest obligations translate into higher ROA and interest coverage metrics. So the bias towards those issuers with big debt burdens is replaced by a bias towards companies with strong cash flows and high credit qualities, a tilt that can create a unique risk/return profile relative to other corporate bond ETFs.

“When you think about capitalization weighting in stocks the drawbacks are fairly evident,” said Research Affiliates founder Rob Arnott in an interview with ETFdb last year. “When you talk about cap weighting in bonds, the drawbacks are flagrantly obvious.” For investors who agree with Arnott and maintain concerns about the combination of fixed income exposure and cap weighting methodologies, CBND may represent a major step forward in the evolution of bond ETFs. As the relative performance of various equity ETFs has shown, the choice of weighting methodology is not a minor decision; the strategy used to determine individual allocations within a portfolio can have a major impact on both bottom line returns and volatility.

Enhanced Flexibility

An increase in the allocation to Treasuries within broad-based bond bond ETFs has corresponded with a steady drop in interest rates, creating an environment where inclusion of investment grade corporate bonds can provide both a better balance of fixed income exposure and sufficient current income. More options in this asset class have given investors tools to fine tune corporate debt exposure, in order to better meet the needs of an individual portfolio.

Disclosure: No positions at time of writing.

Disclaimer: ETF Database is not an investment advisor, and any content published by ETF Database does not constitute individual investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. From time to time, issuers of exchange-traded products mentioned herein may place paid advertisements with ETF Database. All content on ETF Database is produced independently of any advertising relationships.

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Source: CBND vs. LQD: Which Is the Better Corporate Bond ETF?