The new wave of smart-beta indexing methodologies is not limited to stock exchange traded funds. Some bond ETFs follow alternatively weighted indices as well.
The largest and most popular corporate bond ETFs typically track a traditional market-capitalization-weighted index that focus on the most indebted issuers.
“Skewing toward the most-indebted issuers may be particularly problematic in the high-yield bond market because these issuers may carry greater default risk than their less indebted counterparts,” according to Morningstar analyst Alex Bryan. “The biggest debtors may also be more likely to suffer a credit-rating downgrade, which could hurt performance.”
On the other hand, investors can consider alternative index-based bond ETFs, such as the PowerShares Fundamental High Yield Corporate Bond ETF (NYSEArca: PHB). PHB tries to reflect the performance of the RAFI Bonds US High Yield 1-10 Index, which selects debt securities based on fundamentals such as the company’s size, sales, cash flow, dividends and book value of assets.
Consequently, the fundamental indexing methodology could diminish the ETF’s exposure to the most heavily indebted companies while other high-yield bond ETFs would weight holdings by market value.
However, the alternative indexing methodology could steer a fund toward less liquid debt in the fixed-income markets, potentially raising the cost of managing the portfolio. Consequently, PHB limits holdings to issues with at least $350 million in par value outstanding.
Additionally, PHB excludes some of the junkiest debt, compared to other junk-bond ETFs in the space. The ETF’s credit quality breakdown includes BBB 10%, BB 63% and B 26%. In contrast, the iShares iBoxx $ High Yield Corporate Bond ETF (NYSEArca: HYG) includes BBB 5.0%, BB 49.9%, B 29.8%, below B 11.8% and not-rated 3.5%. [Indexology®: High Yield Bonds: Can more juice get squeezed out of the junk bond sector?]