Alternatives To Standard Corporate Bond ETFs

In a year of record-breaking inflows for fixed-income exchange-traded funds and investment-grade corporate bond funds are among investors' preferred destinations. Three of the top 10 ETFs in terms of new assets added this year are bond funds, and two of those three are investment-grade corporate bond ETFs.

The oldest and largest corporate bond ETFs are typically cap-weighted, meaning the largest oustanding issues command the biggest percentages of those funds' weights. However, there are alternative ways of viewing corporate bonds with ETFs. Consider the WisdomTree Fundamental U.S. Corporate Bond Fund (BATS: WFIG).

WFIG can be a complement or alternative to traditional investment-grade corporate bond exposure because its underlying index, the WisdomTree Fundamental Corporate Bond Index, selects bonds “that are deemed to have attractive fundamental and income characteristics,” according to WisdomTree.

Added Factors

There is more to WFIG's secret sauce than simply eschewing weighting by issue size. Three other factors are part of the fund's weighting methodology.

“The WisdomTree fundamentally weighted strategy for corporate bonds utilizes three time-tested factors to screen for quality: free cash flow over debt service, leverage ratio and return on invested capital (ROIC),” said WisdomTree in a recent note. “Our work has shown that a deterioration in these factors for IG has served as a precursor for a potential downgrade, while declining and negative free cash flow has led to financial distress in the HY universe. For IG, the worst 20% factor scores by sector are then cut, while in HY, all issuers with negative free cash flow are removed.”

WFIG has an effective duration of 7.4 years. Duration measures a bond's sensitivity to changes in interest rates. The ETF has an embedded income yield of almost 3.1 percent and a 30-day SEC yield of nearly 2.9 percent.

Credit Quality

Credit quality is often investors' concern when considering corporate bonds, but as an investment-grade fund, WFIG shies away from riskier fare. Nearly 90 percent of the ETF's almost 80 holdings are rated BBB or A. WFIG employs other steps to minimize credit risk.

“This smart beta approach focuses only on public issuers domiciled in the U.S. and employs a stringent issue-size criterion to help alleviate some liquidity concerns,” said WisdomTree. “Along the same lines, for HY, there is an additional liquidity screen where 5% of the smallest and oldest issuers are eliminated. Oftentimes, eliminating troubled credits can involve a sacrifice in overall yield. I believe a focus on improved quality can be worth that trade-off, but our strategy also tilts weight back toward the bonds that remain with more favorable income traits to help offset some of that loss.”

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