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ETF Specialist

Better Bond ETFs?

A new crop of rules-based bond ETFs is attempting to improve on traditional market-cap-weighted alternatives.

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A version of this article was published in the June 2016 issue of Morningstar ETFInvestor. Download a complimentary copy of ETFInvestor here.

There's a lot to like about market-cap-weighted bond index funds. They offer low fees, a consistent and transparent approach with no key-manager risk, and low transaction costs because they favor the most-liquid issues and have fairly low turnover. But market-cap weighting may not be the optimal way to construct a bond portfolio because it tilts toward the most heavily indebted issuers. The implications of this are different in the investment-grade and high-yield market segments. In the investment-grade market, cap-weighting skews most portfolios toward low-yielding Treasuries and agency mortgage-backed securities, dragging down expected returns. In the high-yield market, the biggest debtors may have particularly high credit risk.

Alex Bryan does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.