Bond ETF Revolution? State Street Plans Fundamental Fixed Income Fund

State Street, the Boston-based firm that maintains a broad-based lineup of fixed income ETFs, recently made an interesting SEC filing detailing plans for a new type of bond ETF. The proposed SPDR Barclays Capital Issuer Scored Corporate Bond ETF (CBND) would seek to replicate the performance of the Barclays Capital Issuer Scored Corporate Index, a benchmark that uses fundamental factors to determine underlying holdings.


The majority of fixed income benchmarks that serve as the basis of ETFs are cap weighted, meaning that the larger an eligible debt issue by market value, the larger the weighting within the index. But closer scrutiny on index construction and maintenance methodologies has caused some to rethink the manner in which they achieve fixed income exposure. Last year, PowerShares switched the index linked to its high yield bond ETF (PHB) to the RAFI High Yield Bond Index, a benchmark developed by Research Affiliates. That index uses a “RAFI weight” to determine eligible components and corresponding weightings; RAFI weights take into account four fundamental factors of the issuer, including book value, gross sales, gross dividends, and cash flow. As such, the methodology has a tendency to identify issuers with strong underlying fundamentals, as opposed to simply highlighting the biggest debtors .
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The proposed fund from State Street has some similarities to the methodology behind PHB, as well as some noticeable differences. As far as the differences, the State Street ETF would focus on investment grade debt; securities eligible for inclusion in the underlying index include publicly issued U.S. dollar denominated corporate issues that are rated investment grade (Baa3/BBB- or higher) by at least two of the three major ratings agencies and have $250 million or more of par amount outstanding. And the fundamental factors used to screen debt are different as well; individual issuers in the index are weighted using three fundamental financial ratios, including return on assets, interest coverage (EBIT/Interest Expense), and current ratio al weighting has become increasingly popular in the equity space, where a handful of products from various issuers are linked to fundamentally-weighted indexes [see ProShares Launches Long/Short RAFI ETF]. But fundamental weighting has been slow to catch on in the fixed income arena; so far, PHB is the only bond ETF to embrace the RAFI methodology.

Corporate Bond Market: Heating Up

Although it seemingly took forever for companies to develop a diversified lineup of bond ETFs, it appears as if many investors are now embracing the exchange-traded structure as a means of achieving fixed income exposure. Currently, there are 21 ETPs in the Corporate Bond ETFdb Category including four that have more than one billion dollars in assets under management (in aggregate, there is well over $25 billion invested in investment grade corporate bonds ETFs, underscoring the increasing importance of this sector in the low interest rate environment).
In addition to broad market funds such as the ultra-popular LQD, more targeted products also exist, including several funds from Guggenheim that target bonds maturing in a specific year. While the space is growing increasingly crowded, there is still plenty of room for growth in the industry, especially given that the corporate bond market is worth well over $30 trillion dollars in total.
No expense ratio details were included in the filing; the average for the Corporate Bonds ETFdb Category is just 0.23%.


Disclosure I am long LQD and PHB shares