Fundamental Indexing Comes To Investment Grade Bond ETFs

State Street Global Advisors launched the SPDR Barclays Capital Issuer Scored Corporate Bond ETF (CBND) on Thursday (4/7/11).  The underlying benchmark index intends to measure the performance of the U.S. corporate bond market.  Instead of a traditional weighting methodology, individual issuers in the index are weighted (“scored”) on fundamental factors: return on assets, interest coverage, and current ratio.

CBND is, according to the prospectus, a passively-managed index fund.  However, it employs an extreme sampling strategy that includes fewer than 7% of the 3,500+ holdings in the underlying index.  The small sample (currently 234 holdings) means that CBND is in effect an actively-managed ETF.  Calling it an index fund allowed State Street to avoid obtaining additional exemptive relief from the SEC.

Typically with ETFs, investors can assume the fund's characteristics are very similar to those of the index, with the usual adjustment for expenses.  With CBND, the degree of sampling forces us to distinguish more carefully between the two.

The Index

The Barclays Capital Issuer Scored Corporate Bond Index is designed to measure the performance of the U.S. corporate bond market.  It includes publicly traded corporate bonds that are rated investment grade.  Only bonds issued by companies with publicly traded equity are eligible for inclusion.  In addition, the securities must be denominated in U.S. dollars, fixed rate, and non-convertible.  The index includes only the “corporate” sectors, which are defined as Industrial, Utility, and Financial Institutions.

Individual issuers are weighted using the following financial ratios: return on assets, interest coverage, and current ratio (“factors”).  Individual security weights are then calculated by the relative market value of each eligible security issued by the issuer.  Monthly rebalancing to reflect the addition and subtraction of securities occurs the last business day of each month.  Factor rebalancing occurs every six months (end of March and September).

The index has more than 3,500 holdings, a current yield of 5.4%, and a modified adjusted duration of 6.1 years.

The ETF

The fund employs a sampling strategy, which means that it is not required to purchase all of the securities represented by the index.  CBND has just 234 holdings (6.7% of index holdings), an expense ratio of 0.16%, current yield of 5.0%, and a modified adjusted duration of 5.8 years.

Because of the sampling strategy used by the fund, the 10 largest fund holdings are completely different from the 10 largest index constituents.  Top fund holdings include HSBC Finance Corp (5.7% 6/1/11) 1.3%, Bank of New York Mellon (4.3% 5/15/14) 0.9%, Enterprise Products Operating (7.625% 2/15/12) 0.9%, Nationwide Health Properties (6.5% 7/15/11) 0.9%, Thermo Fisher Scientific (2.15% 12/28/12) 0.9%, Continental Airlines 2007-1 (5.983% 4/19/22) 0.9%, and Eastman Chemical Co (3% 12/15/15) 0.8%.  The fund's sector allocation comes in at Industrials 55.8%, Financials 32.3%, and Utilities 10.2%.

The Competition

CBND faces no direct competition.  The closest alternative is iShares iBoxx $ Investment Grade Corporate (LQD) (LQD overview), the entrenched leader of corporate bond ETFs.  Currently only one other bond ETF uses fundamental weighting, but it does not hold investment grade securities.  PowerShares Fundamental High Yield Corporate Bond (PHB) (PHB overview) implemented a fundamental weighting strategy for its high yield bond portfolio in August 2010.

The Conclusion

SPDR Barclays Capital Issuer Scored Corporate Bond ETF (CBND) is one-of-a-kind.  It is the first ETF to bring fundamental weighting techniques to investment grade bonds.  The extreme sampling increases the risk of tracking error, but since the index is not widely followed this should not be a huge concern.  Investors will likely judge this fund on its own merits, not those of the index.  As a result, I suspect CBND will be successful for State Street and will eventually spawn competitors.

The CBND overview page provides data on quality breakdown, maturity ladder, and other characteristics for both the fund and the underlying index.  Additional information is available in the fact sheet (pdf) and prospectus (pdf).

Disclosure covering writer, editor, and publisher: No positions in any of the securities mentioned. No positions in any of the companies or ETF sponsors mentioned. No income, revenue, or other compensation (either directly or indirectly) received from, or on behalf of, any of the companies or ETF sponsors mentioned.