How to evaluate corporate bond ETFs

Corporate bonds are a core part of the investment universe, and for many investors provide a crucial source of retirement income. However, the asset class is fairly complicated, and investors need to take into consideration a number of different metrics to assess how their investment may perform.

The value of investments can fall as well as rise, and you may get back less than you invested. Past performance is no guarantee of future results

Exchange traded funds (ETFs) have really opened up corporate bonds to individual investors, and there are now a plethora of different corporate bond ETFs which investors can purchase. They range from short-dated bonds, investment grade and high yield debt (historically known as ’junk bonds’), to bond ETFs that exclude certain sectors such as financials.

The majority of corporate bond ETF factsheets provide their holders with a series of statistics on the underlying holdings within the ETF. However, as with many products from the world of finance and investments, there is an infuriating number of ways to calculate rather similar-sounding portfolio characteristics.

From the perspective of an investor, who wants to make a judgement on whether they should purchase an ETF, the most important numbers are Yield to Maturity (YTM), Effective Duration and Credit Quality. In addition, and unfortunately this is rarely stated, is the Option Adjusted Spread (OAS) which is used to determine the excess return over comparable government bonds that an investor may receive from taking on company credit (or default) risk

In the next few paragraphs we outline how you should interpret these measures, when you assess whether or not to purchase a corporate bond ETF.  

Yield to Maturity

YTM is the yield that an investor purchasing the ETF today would receive before any defaults, while the Yield to Worst (YTW) accounts for call provisions within the bonds and is always slightly lower. For example, a holder of the iShares Core GBP corporate bond ETF (SLXX) would receive a YTM of 2.2% if the bonds were held to maturity (as of 9 June 2017) and there were no defaults.

To look at the historic YTM of this ETF, we used data from the Bloomberg GBP Corporate Bond Index in Chart 1 which has very similar underlying holdings. Since 2010, the YTM of the index has fallen from 5% to 2.2%, meaning that investors will receive a lower return on an ongoing basis than they would have done before.

Chart 1: Bloomberg GBP Corporate Bond Index – Yield to Maturity

YTM is a very different number from the Distribution Yield, which looks at historical yield (usually over the prior 12 months), and Weighted Average Coupon (WAC) which looks purely at the annual interest rate paid by the bond when priced at 100. As bonds can trade a premium of discount to par value (i.e. 100), and historic performance is arguably very misleading, these figures can be largely disregarded. 

Effective Duration

Effective Duration measures the sensitivity of a bond to changes in interest rates. The higher the number, the more sensitive the portfolio. Looking at iShares Sterling Corporate Bond Fund (SLXX) and the iShares Sterling Corporate Bond 0-5 year (IS15), the former has a duration of 9.2 years, and the latter of 2.6 years. This means that if interest rates rise by 1%, you could expect SLXX to fall in value by 9.2%, with IS15 declining in value by 2.6%.

Duration is inversely related to yield. The higher the yield of the ETF, the lower the sensitivity of the portfolio to interest rates. Therefore High Yield ETFs have a lower duration than Investment Grade bonds (see Chart 3).

We can see in Chart 2 that the duration of the index has risen over time, while the yield (Chart 1) has fallen. This has made corporate bonds more risky investments.

Chart 2: Bloomberg GBP Corporate Bond Index – Effective Duration

Credit Quality

Credit Quality is measured by ratings agencies, usually S&P, Fitch and Moody’s. The agencies all have slightly different ways of classifying bonds:

Chart 3: Ratings agency credit quality scale

AAA bonds are seen as the least likely to default (typically government bonds), and down to BBB they are known as ‘Investment grade.’ Bonds rated from BB down to single C are now commonly known as ‘High yield’, or colloquially as ‘Junk bonds’. High yield bonds, as the name suggests, have a significantly higher yield than Investment grade debt but carry a significantly higher risk of defaulting. When bonds default, they are usually removed from high yield indices and enter the illiquid and specialist world of ‘Distressed debt’ investing.

Option Adjusted Spread (OAS)

This is measured in ‘basis points’ (one basis point is 0.01%), and represents the yield enhancement that an investor in corporate bonds is receiving over similar government bonds once call provisions have been accounted for. It is effectively the risk premia that the market asks for in exchange for taking on company credit risk. When the OAS is widening (it peaked at 282 basis points in December 2011), corporate bonds underperform government bonds, and when it narrows, corporate bonds will outperform.

Currently investors in the Bloomberg GBP Corporate Bond Index would receive a yield enhancement of 1.15% over comparable government bonds, which is at the lower end of the scale. A small increase in company defaults would erode the higher yield differential.

Chart 4: Bloomberg GBP Corporate Bond Index – Option Adjusted Spread

What’s the next step?

Corporate bonds are widely used in risk managed investment allocations such as IG Smart Portfolios, to provide income and a risk offset to equity allocations. Currently IG Smart Portfolios are running a short duration and high credit quality to protect value if yields rise and market volatility increases. 

You can also use our ETF screener to find the right corporate bond ETFs for you. ETFs can be bought on IG’s share dealing platform, where commissions start at just £5 and there are no custody or platform fees.

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