From FlexShares
With a vast and growing menu of fixed income ETFs to choose from, using the right data points to evaluate, compare, and select bond ETFs can be a complex process. To that end, we’ve identified four metrics that are key to understanding a fixed income ETF’s characteristics:
* An embedded option is a component of a financial security that gives the issuer or the holder the right to take a specified action in the future.
1. WEIGHTED AVERAGE OPTION ADJUSTED SPREAD
What this metric means
A bond’s option adjusted spread is the difference between its yield and the current risk-free rates (typically US Treasury rates), adjusting for any embedded options*. For a fixed income ETF, the weighted average option adjusted spread is calculated by weighting the option adjusted spreads of the underlying bonds by their market value in the portfolio.
A bond ETF’s weighted average option adjusted spread measures the credit risk of its option-embedded bonds. This is possible because the metric removes the embedded options*, thereby isolating the option for analysis.
How investors can use it
Weighted Average Option Adjusted Spread can give advisors an idea of whether a bond ETF is a worthwhile investment after taking the risk of its embedded options* into account. As options may introduce additional risk, an investor could expect a lower price and a higher yield in order to be compensated for the risk.
For example, if an investor is comparing two bond ETFs with embedded options*, this metric can be helpful in identifying which has the higher option adjusted spread and lower price, offering the potential for higher yield.
2. WEIGHTED AVERAGE MATURITY (WAM)
What this metric means
A bond’s maturity date is the date on which the bond issuer agrees to repay the investor the original sum owed—also known as the principal amount. For a fixed income ETF, Weighted Average Maturity (WAM) is calculated using each bond’s maturity date weighted by its market value in the portfolio. The higher the WAM, the longer it may take for all of the bonds in the ETF to mature.
How investors can use it
WAM can be used as a tool to manage fixed income portfolios, where the investor may choose a bond ETF that matches a time frame specified by a client’s investment goals. WAM can also be a useful tool for bond laddering strategies, where the investor purchases bonds with different maturity dates such that principal may be returned to the investor at different times, thereby potentially reducing reinvestment risk.
3. WEIGHTED AVERAGE EFFECTIVE DURATION
What this metric means
A bond’s effective duration is the sensitivity of its price to a change in interest rates. This metric is designed for bonds with embedded options*. For a fixed income ETF, the weighted average effective duration is calculated by weighting the effective duration of the underlying bonds by their market value in the portfolio.
Weighted average effective duration reflects how much the price of a bond ETF may rise/decline when interest rates fall/rise 1%. This figure is expressed in years, and the higher the number, the more volatile the price change is expected to be. In addition, as a general rule, the longer a bond ETF’s maturity, the longer its weighted average effective duration.
How investors can use it
Weighted average effective duration can be a helpful tool to evaluate the interest rate risk of a bond ETF. Investors can also use the metric to express views on interest rate movements. For example, if an investor expects interest rates to rise, a bond ETF with a low weighted average effective duration can express this conviction.
4. WEIGHTED AVERAGE YIELD TO WORST
What this metric means
Yield to worst is a metric designed for bonds with early retirement provisions (most commonly referred to as a call option). It represents the lowest possible yield the bondholder may receive if the bond were retired early. For a fixed income ETF, the weighted average yield to worst is calculated by weighting the yield to worst of each underlying bond by its market value in the portfolio.
A bond’s yield to worst will always be lower than its yield to maturity, as it represents a shortened investment period. The two metrics would be equal for bonds with no early retirement provisions.
How investors can use it
During times of falling interest rates, weighted average yield to worst can be a particularly useful metric. This is because issuers of bonds with call options are more likely to call them as rates fall, as they can likely obtain a lower coupon rate through new issuance. Thus, the yield to worst provides a better indication of the yield the bondholder may receive before it is called.
CONCLUSION
Fixed income remains an important component of many investors’ portfolio holdings, offering the potential for diversification and income generation. No matter the interest rate environment, investors need to be aware of the metrics that can help them evaluate a fixed income ETFs potential effectiveness within their portfolio.
FIND OUT MORE
The FlexShares approach to investing is, first and foremost, investor-centric and goal oriented. We pride ourselves on our commitment to developing products that are designed to meet real-world objectives for both institutional and individual investors. If you would like to discuss the attributes of any of the ETFs discussed in this report in greater depth or find out more about the index methodology behind them please don’t hesitate to call us at 1-855-FlexETF (1-855-353-9383).