Cap Weighting Isn't Necessarily Risky With These Bond ETFs

As is the case with many equity-based exchange traded funds, some of the largest fixed income ETFs use cap-weighted indexes, meaning the largest debtors are among those funds’ top holdings. That includes the iShares iBoxx $ Invmt Grade Corp Bd ETF (NYSEArca: LQD), the largest corporate bond ETF.

LQD seeks to track the investment results of the Markit iBoxx USD Liquid Investment Grade Index composed of U.S. dollar-denominated, investment-grade corporate bonds. LQD allocates 95 percent of its total assets in investment-grade corporate bonds to mitigate credit risk. However, cap weighting is not necessarily risky with investment-grade corporate bond ETFs.

“It may seem intuitive to conclude that the largest debtors are the riskiest, which has led to the idea that these index funds are poor investments,” said Morningstar in a recent note. “This notion is inaccurate, particularly in the investment-grade realm. The largest issuers tend to be large enterprises with the cash flow necessary to support their debt. They are not necessarily more leveraged or riskier than smaller issuers. The bond origination process, which takes investor demand into consideration, also helps prevent companies from issuing too much debt.”

Inside LQD ETF

Temping yields and improved balance sheets at large U.S. companies are among the reasons why some financial advisors are favoring exchange traded funds that invest in investment grade corporate bonds. LQD has a duration of 8.45 years.

“LQD tended to tilt toward slightly higher-quality debt than most of its peers in the corporate-bond Morningstar Category from 2014 to 2017,” according to Morningstar. “This was partially because many actively managed strategies invested in junk bonds. While market-value-weighted corporate-bond funds may not always have a higher-quality orientation than active managers, this data suggests that market-value-weighting doesn’t necessarily lead to a bias toward lower-quality issuers.”

Investors considering an ETF like LQD while looking to mitigate interest rate risk may want to evaluate the iShares Interest Rate Hedged Corporate Bond ETF (NYSEARCA: LQDH). LQDH holds LQD with short positions in interest rate swaps. LQDH “seeks to mitigate the interest rate risk of a portfolio composed of U.S. dollar-denominated, investment grade corporate bonds,” according to iShares.

For more trends in fixed income, visit the Fixed Income Channel.

The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.