August 12, 2021 | Vanguard Perspective

Clients searching for yield? Consider corporate bond ETFs

Faced with a market environment of historically low bond yields and interest rates, advisors may be struggling to find a suitable bond portfolio construction approach for their clients. Lower yields mean the bond portion of a portfolio generates less income. It also means that it is increasingly difficult for investors to hit certain yield targets without taking on a greater level of portfolio risk.

Your search for yield may lead you to consider an overweight to dividend-paying stocks or differentiated fixed income investments such as high-yield and emerging markets bonds. However, dividend strategies come with a higher level of risk than most bond offerings while not diversifying equity risk. And the aforementioned fixed income investments can meaningfully change the risk profile of a client’s bond allocation.

Corporate bond ETFs can enhance the income potential of a bond allocation

U.S. investment-grade corporate bonds, particularly when accessed via ETFs, are a good way to enhance the income potential in a bond portfolio in a risk-aware, low-cost manner, while also potentially improving long-term risk-adjusted returns.

Currently, the yield to maturity on a broad-market investment-grade corporate bond ETF such as Vanguard Total Corporate Bond ETF (VTC), is 2.09%, a premium of 0.59% over the yield to maturity on the U.S. aggregate bond market and 1.14% premium over the yield to maturity on the broad U.S. Treasury market.1

It's important to keep in mind that credit risk—the risk that companies may be downgraded or default on their debt—is what mainly drives the yield premium. While this credit risk leads corporate bonds to have a higher return correlation to stocks than to U.S. Treasuries, corporate bonds still offer risk-reduction benefits relative to an equity allocation. And most U.S. investment-grade bonds tend to be of high quality, having an average credit-quality rating of A–.

Why ETFs for corporate bond exposure?

ETFs have become an established vehicle for investing in the corporate bond market given their diversification, low-cost, versatility, and tax efficiency. We've seen explosive growth in U.S. investment-grade corporate bond ETFs over the past 10 years in both assets under management (AUM) and product count.

Growth of corporate bond ETFs

This combination line and area chart shows the growth of corporate bond ETF products and assets under management from 2010 until June of 2021. The number of corporate bond ETFs has grown from 20 in 2010 to over 50 in 2021. Assets under management have risen from approximately $25 billion in 2010 to close to $200 billion through June of 2021. There was a significant spike in asset growth from 2018 through 2021.

Source: Vanguard, using Morningstar data, as of June 30, 2021.

Note: Based on U.S.-listed, ex-ETN (exchange-traded note) issues only. Corporate bond ETF AUM and product count are inclusive of Morningstar’s Corporate Bond category as well as ETFs in the Short Bond and Long Bond categories that have at least 80% of assets invested in corporate bonds.

Evaluating corporate bond ETFs

When evaluating corporate bond ETFs, here are three important things to consider:

1. The exposure offered by the ETF

Understanding the index methodology behind the ETF is critical to help ensure it fits as an appropriate component in the portfolio. Corporate bond ETFs can be differentiated by their maturity/duration exposure (for instance, broad market or short-, intermediate-, or long-term), their credit quality (for instance, some focus on bonds rated at or above one particular rating), or the types of companies they focus on (e.g., sub-sectors or companies that pass certain ESG [environmental, social, and governance] screens). 

2. The ability of the fund manager to tightly track the index

Unlike in most equity index ETFs, it is nearly impossible for a bond ETF to own every bond in the index in its precise weight. This is especially true when it comes to the corporate bond market.

In order to tightly track a benchmark, the manager must employ a sophisticated process of optimization.

Our optimization process entails replicating the risk factors of a bond ETF’s benchmark. Every day, we match the ETF’s exposures to duration, credit quality, sector exposure, and many more factors to those of the benchmark, within a fraction of a basis point. We strive to own 90%-plus of the bonds in each benchmark, meaning there are thousands of bonds in our diversified index ETFs.

3. Investment costs

ETFs have lowered the cost of investing in the corporate bond market dramatically. In 2010, the average corporate bond mutual fund expense ratio was 0.97%.2 Compare that with the 2020 average corporate bond ETF expense ratio of 0.18%, and you can see the impact ETFs have had on lowering costs in this segment of the bond market.2

ETFs also confer transaction-cost liquidity. Because it trades on an exchange, the bid-ask spread for a bond ETF depends not only on the liquidity of its underlying bonds but also on its own trading volume. Many corporate bond ETFs are among the most traded ETFs in the world, trading at spreads that are a tiny fraction of the basket spreads, or implicit cost of investing in all the bonds they hold. 

Vanguard corporate bond ETFs trade at a fraction of the cost of their underlying bonds

This bar chart compares the ETF spread to the ETF basket spread for four of our corporate bond ETFs, showing that the ETF spread is a fraction of the basket spread. The ETF spread for VCSH is 0.01% compared to 0.09% for the basket spread. The ETF spread for VCIT is 0.01% compared to 0.16% for the basket spread. The ETF spread for VCLT is 0.07% versus 0.35% for the basket spread and the ETF spread for VTC is 0.06% as compared to 0.21% for the basket spread.

Source: Vanguard, using Bloomberg data as of June 30, 2021.

Note: Vanguard estimated the underlying bond bid-ask spread using Bond Liquidity Analysis, a proprietary calculation that uses Bloomberg data to estimate an aggregated bid-ask spread for the underlying portfolio of bonds for the 20 trading days ended June 30, 2021.

Our corporate bond ETFs offer a maturity-segmented approach

As one of the largest managers of corporate bond ETFs, including Vanguard Intermediate-Term Corporate Bond ETF (VCIT)—the largest corporate bond ETF in the world, we bring a wealth of bond-indexing expertise and experience to our lineup.3

Vanguard ETF® (ticker) and expense ratio4

Total Corporate Bond ETF (VTC)   0.05%

Short-Term Corporate Bond ETF (VCSH)   0.05%

Intermediate-Term Corporate Bond ETF (VCIT)   0.05%

Long-Term Corporate Bond ETF (VCLT)   0.05%

ESG U.S. Corporate Bond ETF (VCEB)   0.12%

 

1 Source: Bloomberg Barclays indexes as of June 30, 2021.

2 Source: Vanguard, using Morningstar, Inc., data as of December 31, 2020.

3 Source: Morningstar, Inc., as of June 30, 2021.

4 As reported in each fund's most recent prospectus. A fund's current expense ratio may be higher or lower than the figure shown.

 

Glossary

Investment-grade
A level of credit rating which signifies that a municipal or corporate bond presents a minimal risk to investors.

Yield to maturity
The total return anticipated on a bond if the bond is held until its maturity date.

Duration
A measure of the price sensitivity to a change in interest rates.

Bid-ask spread
The difference between the highest price that a buyer is willing to pay for an asset and the lowest price that a seller is willing to accept.

Basket spread
Defined as the weighted-average bid-ask spread of the underlying basket securities for some period (e.g., 5, 20, 30) of trading days.

Notes:

  • For more information about Vanguard funds or Vanguard ETFs, obtain a prospectus (or a summary prospectus, if available) or call 800-523-1036 to request one. Investment objectives, risks, charges, expenses, and other important information are contained in the prospectus; read and consider it carefully before investing.
  • Vanguard ETF Shares are not redeemable with the issuing Fund other than in very large aggregations worth millions of dollars. Instead, investors must buy and sell Vanguard ETF Shares in the secondary market and hold those shares in a brokerage account. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.
  • All investing is subject to risk, including possible loss of principal. Be aware that fluctuations in the financial markets and other factors may cause declines in the value of your account. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income.
  • Bond funds are subject to interest rate risk, which is the chance bond prices overall will decline because of rising interest rates, and credit risk, which is the chance a bond issuer will fail to pay interest and principal in a timely manner or that negative perceptions of the issuer’s ability to make such payments will cause the price of that bond to decline.
  • Diversification does not ensure a profit or protect against a loss.