Owning big debtors doesn't mean more risk for these bond ETFs

Market-value-weighted bond ETFs will not be crushed by the large debt loads imposed by their indexes.

Phillip Yoo 9 October, 2018 | 5:00PM

Market-value-weighted corporate-bond index funds are naturally biased toward the largest debt issuers. It may seem intuitive to conclude that the largest debtors are the riskiest, which has led to the idea that these index funds are poor investments. This notion is inaccurate, particularly in the investment-grade realm. The largest issuers tend to be large enterprises with the cash flow necessary to support their debt. They are not necessarily more leveraged or riskier than smaller issuers. The bond origination process, which takes investor demand into consideration, also helps prevent companies from issuing too much debt.

From 2007 to 2017, the largest 10 U.S. corporate issuers' median leverage, as measured by debt/EBITDA, was on par with the median leverage of all publicly traded U.S. issuers, according to estimates by Goldman Sachs. The median leverage ratio for the largest 10 issuers hovered slightly below 3.0 times, and the corresponding figure for all publicly traded issuers was slightly above 2.5 times.

The leverage ratio figures illustrate that the total market value of outstanding debt must be analyzed in context. Just because a company is an active debt issuer, it doesn't necessarily make it riskier. For example,  CVS Health (CVS) is one of the largest debt issuers in the United States with over US$65 billion of obligations coming due in the next 30 years. Bonds issued by CVS Health are universally held by popular market-value-weighted corporate-bond exchange-traded funds, such as BMO Mid-Term US IG Corporate Bond Index ETF (ZIC), which has a Morningstar Rating of 4-stars, and 3-star rated iShares U.S. IG Corporate Bond Index ETF (XIG), which holds units of the U.S.-sold, bronze-rated  iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD).

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About Author

Phillip Yoo

Phillip Yoo  Phillip Yoo is a manager research analyst for Morningstar Research Services LLC, a wholly owned subsidiary of Morningstar, Inc. He covers passive strategies, focusing on fixed-income exchange-traded funds across the credit spectrum.

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