Editor's Note: This blog has been updated to include more recent data. It was originally published in November 2018.
Fixed income ETFs have grown exponentially in the past decade, resulting in an ever-expanding user base that ranges from wealth managers and institutional investors to individual investors and financial advisors. Whenever a new investment tool is incorporated into portfolios, it tends to generate questions and misconceptions, especially when that tool—an ETF—is combined with debt—a more esoteric asset class than equities.
One misconception I’m hearing is that index-based investments, and therefore many fixed income ETFs, are overweight the most indebted companies, which means that investors are left holding exposure to only the riskiest companies. While this concern is understandable, it’s also easy to debunk. Here are three reasons that looking at the amount of debt an issuer has in an index does not mean you’re left holding a high-risk fixed income ETF:
1. Fixed income ETFs do not own an issuer’s entire debt. Fixed income indices are rules-based and are designed to ensure investabilityby focusing on diversification and liquidity. This means a fixed income index does not hold the entire sum of an issuer’s outstanding debt. Because issuers can raise various types of debt—such as short-term liabilities or financing denominated in a foreign currency—certain types of their debt may not qualify for inclusion in an index.
The impact of these rules is captured in the chart below, which shows the debt profile of the Top 10 issuers in the Bloomberg Barclays US Corporate Bond Index. The ranking of the most indebted firms in the index is far different than the ranking of the firm’s overall short-and long-term debt.