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.
2. Debt size is not a reflection of a firm’s payment ability. If an issuer has a high level of debt, it doesn’t mean it cannot pay that debt, nor does it mean the company—or the fixed income ETF exposure—is at risk. Firms with a high amount of debt typically also have large asset bases and revenue profiles. If they didn’t, it’s unlikely the market would extend debt financing to these firms. As shown below, the Top 10 issuers of debt within the Bloomberg Barclays US Corporate Bond Index:
Those figures represent 10%, 34% and 10% respectively of the entire S&P 500® Index’s figures. Simply put, companies in the corporate bond index are large, profitable and well-capitalized firms. They are also very well known, given that seven out of these 10 firms rank among the Top 100 most valuable brands in the world, according to Forbes.1
3. Debt level doesn’t directly translate into risk. Holding a high level of debt doesn’t indicate a firm has more risk than one with less debt. If it did, there would be a linear relationship between credit ratings and debt issuance, but that is not the case. Credit ratings account for not only the amount of debt a company issues but also its capacity to service that debt, resulting in a limited relationship between debt issued and credit rating assessed.
We demonstrate this relationship in the table below. We broke out firms within the Bloomberg Barclays US Corporate Bond Index by decile of debt issued, with the first decile representing the largest issuers of debt and the second decile the second largest, so on. The average Bloomberg Composite credit rating was calculated for each decile, first transforming the alphabetical credit ratings into numerical figures (AAA = 1, BB+ = 11) and then calculating the average statistic. The result is that the first decile—or the largest debt issuers—has the highest credit rating, with a value of 7.0 or a rating of Single A-. The 8th decile of debt issuers has the lowest credit rate with a figure of 8.4 or a rating of BBB.
Source: Bloomberg Finance L.P., as of 08/22/2019
At the end of the day, focusing on the amount of debt an issuer has in an index is not a reflection of an ETF’s risk level. When investing in fixed income ETFs, it’s helpful to remember that indices are rules-based exposures that provide exposure to a diversified slice of the corporate bond market, helping to mitigate single-company risk. Additionally, just because a company is a large issuer of debt does not mean it’s a high-risk company. Large issuers of debt are also firms with a large asset base and revenue profile, providing them with the capacity to pay and service the debt on the firm’s balance sheet.
To learn more about how investors are using fixed income ETFs, you can read my earlier blog, Investors Are Choosing Fixed Income ETFs—Here’s Why.
1 “The World’s Most Valuable Brands,” forbes.com, 2019 ranking.
Bloomberg Barclays U.S. Corporate Bond Index
A rules-based market-value weighted index engineered to measure the investment grade, fixed-rate, taxable, corporate bond market. It includes USD-denominated securities publicly issued by U.S. and non-U.S. corporate issuers. To be included in the index a security must have a minimum par amount of 250MM.
S&P 500 Index
The S&P 500, or the Standard & Poor's 500, is an index based on the market capitalizations of 500 large companies having common stock listed on the NYSE or NASDAQ. The S&P 500 index components and their weightings are determined by S&P Dow Jones Indices.
Bonds generally present less short-term risk and volatility than stocks, but contain interest rate risk (as interest rates raise, bond prices usually fall); issuer default risk; issuer credit risk; liquidity risk; and inflation risk. These effects are usually pronounced for longer-term securities. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss.
ETFs trade like stocks, are subject to investment risk, fluctuate in market value and may trade at prices above or below the ETFs net asset value. Brokerage commissions and ETF expenses will reduce returns.
Frequent trading of ETFs could significantly increase commissions and other costs such that they may offset any savings from low fees or costs.