With low interest rates and depressed credit spreads, corporate bonds pose a sort of conundrum for investors.
Investors who choose high quality issuers may be forced to pay on the valuation. Those who flock to high yielding corporate debt can potentially be exposed to financially fragile companies. With these factors in mind, the WisdomTree US Corporate Bond Fund (CBOE: WFIG) is a viable idea for income investors in today’s environment.
“Bonds from high quality issuers, for example, rarely trade at favorable valuations, while higher yielding bonds often come from companies facing operational challenges. The best strategic beta corporate bond ETFs judiciously integrate these exposures to these factors, ”notes Morningstar analyst Neal Kosciulek.
WFIG is an investment grade exchange traded fund, so investors do not take credit risk here. However, lower credit risk alone does not eliminate the chances of being exposed to overvalued bonds. The WisdomTree US Corporate Bond Index, WFIG’s underlying fundamentally-weighted index, reduces valuation issues and improves quality by employing a multi-step process to find the best corporate bonds with income characteristics favorable.
WFIG offers investors a deep bench, as it houses 555 bonds with an embedded income yield of 2.21% and an effective maturity of 9.37 years, according to issuer data.
“WFIG excludes the 20% of issuers in each sector least likely to service their debt and weights the remaining bonds by a market value adjusted according to the value score,” explains Kosciulek. “The value score is equal to the spread multiplied by a probability of default. Bonds with the best value scores in their sector receive double representation in the portfolio, while those with the worst value scores are excluded. “
This methodology has a clear positive impact on credit quality. While the bulk of holdings in traditional corporate bond ETFs are between one and three notches in junk territory, around half of WFIG’s components are rated AAA, AA, or A. In fact, WFIG has more. components rated A and lower with one of the BBB ratings than some other smart beta corporate bond ETFs.
This trend towards quality is also important today, as some investors ignore the warning signs and simply seek return while avoiding quality.
“Bonds representing more than half of the market are rated BBB, the lowest quality rating possible, and three decades of falling yields have increased demand for yield, prompting risk-taking. Therefore, there is an opportunity for quality-oriented strategies to improve risk-adjusted performance over traditional market value-weighted index funds, ”according to Kosciulek.
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