International Corporate Bond ETFs Have Arrived

PowerShares listed the second-ever international corporate bond ETF for trading this week, behind State Street Global Advisor’s international corporate bond product. This falls right in step with the unfolding of the debt crisis in Europe. The PowerShares ETF provides a broad exposure to international, investment-grade corporate bonds issued in developed countries.

PowerShares International Corporate Bond Portfolio (NYSEArca: PICB) is designed to track the S&P International Corporate Bond Index. The index includes investment grade bonds, rated by S&P or Moody’s issued in the following currencies, Australia dollar (AUD), British pound (GBP), Canadian dollar (CAD), Euro (EUR), Japanese yen (JPY), Swiss franc (CHF), Danish Krone (DKK), New Zealand dollar (NZD), Norwegian Krone (NOK) and Swedish Krona (SEK).

Like many other bond indexes, the S&P International Corporate Bond Portfolio uses a modified market valuation methodology. This is similar to a market capitalization methodology, except the allocation of bonds in each currency is limited to no more than 50%. Currently, bonds issued in the Euro have the maximum 50% weighting.

The fund rebalances monthly and contains a feature designed to boost yield. During each monthly rebalance, any currency with more than 10% allocation will exclude the lowest 25% of bonds with the lowest yield. This is an interesting feature and could be viewed as something similar to fundamentally weighting an equity index with a twist. The twist is that the rebalance makes sure the bonds with the lowest yield, which could also mean the bonds with the most recent run up in price, are excluded. Yield reflects risk, so by using this method, the PowerShares International Corporate Bond Portfolio (NYSEAcra: PICB) will keep only average yielding bonds within a currency. Dropping the lowest yielding bonds could possibly mean dropping the strongest bonds in the currency; this could be an unwanted risk, but will make the yield higher than it would be otherwise. In the same way that fundamentally weighting stock indexes use a factor other than price to determine weight, this methodology will be dropping high priced bonds.

Capping Debt

Turnover will also be high, due to this fund’s monthly rebalancing schedule. Typically in investment indexes, a passive investor likes to see very low turnover with not a lot of activity. In this case, however, investors might welcome keeping a tight rein on allocations in this fund, as bond markets can quickly shift. Some ETF investors have argued that bond ETFs do not work because of their overly passive approach to allocating to higher levels of debt.

For example, most bond indexes use a market capitalization style methodology, a system that works great for equity indexes since as a company issues more stock, stock prices will reflect the new ownership dilution. Whereas with bonds, companies and countries can issue debt and artificially get market capitalization as long as the market believes it can repay and will not default.  This is why Japan typically dominates international government issued fixed-income indexes. Japan has a national debt to GDP ratio of 192%. The risk is obvious there, but extremely passive fixed-income indexes will reward that debt level with allocation and not cap it.

The State Street Global Advisor’s two-week-old ETF, The Barclays Capital International Corporate Bond ETF (NYSEArca: IBND), tracks the more passive The Barclays Capital Global Aggregate ex-USD >$1B, which includes bonds over $1 billion in market value. Doing this keeps the fund and index extremely liquid. The ETF is more Euro heavy than its competitor and holds its highest Euro allocation in the relatively strong Eurozone nation of Germany at 18%, immediately followed by US companies issuing in non-US Dollar fixed income at 17%.

The Barclays Capital International Corporate Bond ETF (NYSEArca: IBND) has an expense ratio of 0.55%, while the PowerShares International Corporate Bond Portfolio (NYSEArca: PICB) has a slightly lower cost at 0.50%. With these two funds being issued in such close timeframes, it will be a test to see which ETF emerges as investors’ preferred choice. Both funds have similar targets, prices and coverage zones. The question is whether investors will choose an ETF more concerned with liquidity like IBND, or an ETF capped to improve yield and limited exposure like PICB.

Risk Factors

The international corporate bond market is something that has been missing in the ETF space. There has been exposure to different international fixed income in the arena of emerging market bonds and developed market government debt, but the corporate space has long been empty. International corporate bonds are affected by both the risk factors of the currencies they are issued in and the credit risks of the individual issuer.

The unfolding of credit problems in Europe will be a large determinant of how these funds will perform. Currency will be a major contributing factor if the Euro continues to fall, hurting returns. The funds do contain high quality issues and will be an extremely low cost way to gain exposure to this important part of the global fixed income market. Since these funds are fixed income with total return coming both from price and income, currency will affect income, as it is translated into US Dollar. This could be a huge benefit for income seekers, since currency works in the US investors’ favor.

Bond ETFs are tricky, and definitely not as simple as equity indexes. The differences need to be understood, as well as the historic instances and implications of credit freezes. Bond ETFs can be liquid when the underlying bonds are not, even with large international bond issues such as those in these ETFs. These instances might look like significant tracking error, when the bond market was actually just not trading and no updated prices were being given. An ETF, being liquid, will reflect current prices, even when markets are closed where the underlying bonds trade, like these international issues. Overall, bond ETFs have been seen as efficient even when efficiency measures like tracking error and premiums and discounts look differently.

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