How to Choose the Right Corporate Bond Fund

Choosing the right corporate bond ETF can be a challenge. After all, which funds are best suited to weather whatever comes our way in the new year? According to Vanguard, finding the right ETF is based on “rigorous due diligence no matter what underlying markets are doing.”

“The vast universe of individual corporate bonds and the decentralized nature of the marketplace can make such bonds relatively illiquid and difficult to trade, especially compared with trading a ready-made basket of bonds through an ETF,” according to Vanguard. “Corporate bond ETFs now loom large as liquidity providers, lowering the cost for investors to add corporate credit into their portfolios in a scalable and diversified way.”

So, when selecting corporate bond ETFs on behalf of clients financial advisors should consider three factors: optimization capabilities, the ability to minimize transaction costs, and liquidity.

Optimization capabilities are essential for successfully managing corporate bond ETFs in terms of closely tracking their benchmarks, since it’s often impossible for a passive fund to fully replicate its benchmark. As part of the optimization process, asset managers can take advantage of their experience, resources, and scale to add value.

It’s also important to manage the transaction costs that asset managers incur. In the investment-grade corporate bond market, bid-ask spreads averaged 32 basis points for the 12 months ended Nov. 30. To avoid trailing a benchmark to this degree and to mitigate costs, some asset managers have developed sophisticated trading techniques, such as participating in new issues. Plus, larger fixed income managers are often “Tier 1” clients for big bond desks, which can improve outcomes for clients.

When considering corporate bond ETFs to add to a portfolio, financial advisors should also look into the liquidity of the ETFs. A strong capital markets team and meaningful scale and trading volumes, along with investor-friendly product design, can result in ETFs offering competitive trading spreads.

Vanguard has a suite of corporate bond ETFs, including the Vanguard Short-Term Corporate Bond ETF (VCSH), the Vanguard Intermediate-Term Corporate Bond ETF (VCIT), and the Vanguard Long-Term Corporate Bond Index Fund ETF Shares (VCLT). These funds seek to track the performance of market-weighted corporate bond indexes that include U.S. dollar-denominated, investment-grade, fixed-rate, taxable securities issued by U.S. and non-U.S. industrial, utility, and financial companies.

VCSH tracks the Bloomberg U.S. 1-5 Year Corporate Bond Index, which includes securities with maturities between one and five years. VCIT, meanwhile, tracks the Bloomberg U.S. 5-10 Year Corporate Bond Index, whose securities have maturities between five and 10 years. VCLT follows the Bloomberg U.S. 10+ Year Corporate Bond Index, which has securities with maturities greater than 10 years.

All three ETFs carry an expense ratio of 0.04%.

For more news, information, and analysis, visit the Fixed Income Channel.