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Bond ETFs have become increasingly popular in recent years as a great way for investors to obtain fixed income exposure. These products allow many to gain access to a wide variety of bonds in a single ticker, allowing investors to better diversify their portfolios into this important asset class.
Yet, while many bond ETFs are widely held and traded, they still have some issues. Many major bond ETFs focus in on debt issuance to determine the size of a bond’s holding in a particular ETF. This promotes the firms with the most amount of debt to the largest holdings, suggesting that those who are more in debt take up the biggest spots, not the most ideal situation for risk adverse investors (read Follow Buffett With These Developed Market Bond ETFs).
Additionally, thanks to the massive size of many major bond indexes, a replication strategy must be used, suggesting that returns may deviate slightly from what investors might be expecting. This trend could be further exacerbated by limits on size and liquidity which tend to be more of an issue with multi-billion dollar bond funds than smaller products in the equity space.
In order to avoid this, many investors have looked to actively managed bond ETFs in order to escape the issues. Unfortunately, some of these products have failed to live up to expectations and have weak trading volumes. Lastly, all products in the active bond ETF space have fees that are well above their passive index tracking counterparts, sometimes as much as a full 100 basis points higher.
However, some might not be aware of a ‘third way’ a kind of middle ground between passive and active management in the bond ETF world. Funds that subscribe to this methodology use a fundamental index which looks to strip out some of the notes that are perceived to be of the lowest quality or have minimal potential for capital appreciation going forward (see Go Local With Emerging Market Bond ETFs).
This can help these funds to outperform some of their extremely passive index based counterparts while at the same time, keeping fees much lower in these products than what investors find in the active space. As a result, they could be the best choice for investors concerned about the fixed income world but are still looking to maintain some level of exposure to the bond ETF world.
Below, we profile the three bond ETFs that use this methodology. All three use various fundamental factors in order to assign weights or determine bond holdings. With this approach, there is hope that investors can obtain a better bond ETF investing experience while still keeping fees at a minimal level:
SPDR Barclays Capital Issuer Scored Corporate Bond ETF (CBND)
This fundamentally-weighted bond ETF takes a different approach to investing than what many are used to. Instead of weights by total debt outstanding, the fund tracks the BarCap Issuer Scored Corporate Index which looks to measure firms on a number of financial ratios in order to determine weights.
These ratios include; return on assets, interest coverage ratio, as well as the current ratio. Individual security weights are then calculated by the relative market value of each eligible security, so long as the issues have at least $250 million in bonds outstanding and are U.S. dollar denominated and investment grade (read Is The Bear Market For Bond ETFs Finally Here?).
In total, the ETF holds just over 490 securities in its basket putting a heavy focus on intermediate term bonds. Thanks to this, the ETF has a modified adjusted duration of just 6.1 years, suggesting somewhat low interest rate risk.
In terms of yield, the ETF looks to pay out roughly 3.3% a year, comparable to many bond ETFs in the corporate space. Additionally, investors should note that the product charges just 16 basis points a year in fees making it very competitive from a cost perspective, although bid ask costs will be high in this fund. Nevertheless, CBND has performed favorably when compared to LQD so far in 2012, although it has trailed the popular product over the past 52 weeks.
PowerShares Fundamental Investment Grade Corporate Bond Portfolio (PFIG)
For another choice in the investment grade space, investors can also consider PowerShares’ entrant in the space, PFIG. This ETF follows a Research Affiliates index—the RAFI Investment Grade Bond Index—which looks to expose investors to various top rated company bonds.
The index takes a look at several factors which look to improve the overall quality of the portfolio in the bond ETF. Each note must have at least $500 million in outstanding value while bonds much also have at least one year of call protection. Additionally, the ETF looks to have a focus on the biggest issues from a top rated firm regardless of when they were issued.
Most importantly, however, is that the fund will look to focus on companies that have a high ability to service debt rather than those that have a great deal of bonds outstanding. By doing this, the index provider believes that the link between size and holding amount are broken and that investors can obtain a more appropriate holding profile.
With this focus, the ETF has roughly 150 bonds in its portfolio with a heavy tilt towards intermediate term securities. Fees are also low in this product at .22% per year, although they are slightly higher than CBND (read Time To Get Regional With Bond ETFs).
Volume is also light in this product while the focus on quality does dampen the yield a little. However, for investors who put a premium on safety and ability to pay, this bond ETF could be an excellent choice in the space.
PowerShares Fundamental High Yield Corporate Bond Portfolio (PHB)
If investors prefer a fundamental approach to the junk bond ETF market, PHB is currently the only option available. This product also targets a Research Affiliates benchmark, in this case the RAFI High Yield Bond Index.
Much like PFIG, this index looks to break the link between debt issuance size and weight in a security, giving bigger allocations to better firms. Yet while it is similar to PFIG’s approach, PHB looks to only invest in bonds that have at least $350 million in outstanding notes while securities must be rated at BB+ or lower.
In total, the bond ETF holds 219 securities in its portfolio, putting a very heavy focus on intermediate term securities. Top sectors include the consumer spaces while energy, financial, and communications all make up at least 10% of assets as well.
Although PHB is a high yield product, its payout isn’t that impressive coming in at just 4.9% in the 30 Day SEC Yield terms. This low yield is due to the focus on quality and a higher percentage of bonds at the top end of the junk bond ceiling. This factor, along with the low effective duration of just 4.06 years, are the biggest culprits for the lower payouts.
Investors should also note that fees are somewhat high in the product, coming in at 50 basis points a year. However, the bid ask spread is quite high and trading costs look to be low in the fund (see more at the Zacks ETF Center).
Thanks to this and the low interest rate/credit risk—due to the focus on short to medium term bonds—the ETF could be a great choice for investors who want slightly higher yields but are scared off by some of the issues in the broad bond market. Furthermore, the ETF has easily beaten out broad junk bond ETFs from a capital gains perspective, easily making up for the lower yield on this front.
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Author is long PHB.