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ETF News And Commentary

In the past few quarters, the markets have witnessed speculation about a number of events and their impact on the markets as we head into 2013. ECB’s policy in order to tame the Euro zone crisis, Fed’s implementation of QE3 and the impact of the presidential election are all weighing on the markets as they struggle to find their footing.

This global economic uncertainty coupled with a slowdown in the domestic U.S. growth rate have for long led to a risk aversion climate among investors and an expansionary monetary policy by the Fed—both leading to a frustratingly low interest rate scenario in the economy(read Inside The Two ETFs Up More Than 140% YTD).

On the other side of the ledger are the income-seeking investors who have had to comply with ultra low yields for quite some time now. While most of the high yielding sources from the ETF space seems to be tapped out, there is one segment which has been pretty much overlooked although it looks promising, ‘crossover bonds’ (read 3 Excellent ETFs with More than 4% Yield).

The SPDR BofA Merrill Lynch Crossover Corporate Bond ETF (XOVR) is one such fund that targets this corner of the U.S. bond market. Bonds in this fund are basically fixed income securities that are highly rated in the non-investment grade bond space or they are lower rated in the investment grade bond space (see Market Vectors Files for Innovative Bond ETF).

Launched in June of 2012, XOVR has been able to amass just about $13 million till date and does a daily volume of just around 11,000 shares. This suggests that the product has been highly ignored by the investors. However, below are three reasons that one may want to consider giving this overlooked product a chance in their portfolio:

1) Providing Parity in Risk-Return Tradeoff

Traditionally, high quality bond ETFs are associated with lower yields and low quality (Junk) ones with higher yields. This is due to the default (counterparty) risk premium that the investor takes before investing in the lower rated (i.e. Junk) bond ETFs.

Investing in these two classes of ETFs require different types of risk appetite and the risk-return tradeoff is demonstrated by 1) high yields— high probability of default and 2) low yields—low probability of default.

However, the crossover bond ETF XOVR, provides parity in the risk-return tradeoff and captures the shades of grey between these two scenarios. Thus they provide the opportunity for 1) higher current income —as opposed to investment grade bond ETFs by taking on 2) relatively lesser default risk —as opposed to non-investment grade bond ETFs (see Forget China, Buy These Emerging Market ETFs Instead).

XOVR has a 30 day SEC Yield of 3.40% and a majority of its assets are allocated to investment grade securities, i.e. 55.16% of its total assets are ‘Baa’ rated which is the lowest rating among investment grade bonds.

2) Pricing Differentials During Bond Crossover can be Advantageous

Among all fixed income securities, Crossover Bonds are the most susceptible to being upgraded to investment grade or downgraded to Junk due to their proximity to either rating. However, the rating would depend on individual credit rating agencies.

Nevertheless, when a bond is downgraded to junk from investment grade by one agency, the implied yield rises and the bond price falls. This indicates an entry point at low levels. However, it might happen that another agency after a brief period of time might upgrade their rating on the same bond which pushes implied yield lower, resulting in capital appreciation (see 3 Actively Managed Bond ETFs for Stability and Income).

On the contrary, if a junk bond is upgraded to investment grade by a rating agency, the price of the bond increases, indicating a decent exit point. Now if another agency downgrades it to junk again after a period of time, the capital loss can be avoided.

3) Probability of Potentially Higher Yields at Lower Expenses

As we have already discussed, the crossover bond ETF, XOVR, provides the potential for high yields due to the nature of its target securities. Furthermore it comes at a relatively lower expense especially compared to other high yielding avenues from the Junk Bond ETF space (read HYEM: The Best Choice in Junk Bond ETFs?).

XOVR charges just 30 basis points in fees and expenses compared to a Morningstar category average of 0.51%. Compared to this, JNK charges 40 basis points in annual fees and expenses, whereas HYG charges an expense ratio of 50 basis points.

Other Features

XOVR tracks the BofA Merrill Lynch US Diversified Crossover Corporate Index. The components in the index are mostly U.S. Dollar denominated, thereby eliminating any currency risk. It targets the intermediate end on the crossover bond yield curve suggested by an average maturity of 7.90 years. Also it carries moderate interest rate risk and has a weighted average duration of 5.72 years (see more in the Zacks ETF Center).

Presently, it holds 158 securities in its portfolio and has a 30-Day SEC yield of 3.40%. XOVR has returned 4.35% since its inception, as of 7th November 2012.

 

Data Point

XOVR

Returns (Since Inception)

4.35%

Average Duration

5.72 years

Average Maturity

7.90 Years

Assets Under Management

$13 million

Expense Ratio

0.30%

Average Credit Quality of the Index

BA1

Average Daily Volume

11,000

30 Day SEC Yield

3.40%

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