Most exchange-traded funds (ETFs) track various stock market indices -- broad market indices such as the S&P 500 or Russell 2000, subdivisions of those indices (such as the Russell 2000 Growth Index), international market indices (such as the MSCI Japan Index), or individual industries or sectors (Biotechnology companies, for example). Some ETFs also track various other asset classes. For example, although they are not heavily traded enough for us to follow in this newsletter, two different funds symbols ICF and IYR) track real estate (REIT) companies. We also will soon see a fund that tracks the gold market, and there are already several funds that track the bond market. I previously wrote an "ETF Spotlight" article that discussed the three U.S. government bond funds (please visit this link to view that analysis).

In this week's "ETF Spotlight" I'm going to cover the iShares Goldman Sachs InvesTop Corporate Bond Fund (LQD), which is designed to track the index of the same name. The index is meant to provide a representative sampling of very liquid investment-grade corporate bonds issued in U.S. dollars by firms domiciled in the United States, Canada, Japan or Western Europe. The bonds must be rated investment grade by both Moody's and Standard and Poor's (S&P) and must have at least $500 million outstanding (at face value). The debentures in the index must also have at least three years remaining time to maturity and they cannot be more than five years old. Finally, the bonds must be registered with the SEC (they cannot be "Eurobonds," which are debt securities that might be issued in U.S. dollars, but generally cannot be easily bought or sold by U.S. investors).

The index, which is updated monthly, has other rules that eliminate certain bonds that might have very high price volatility or whose spreads to Treasuries are too wide. The spread to Treasuries (bonds issued by the United States Government) is seen as a proxy for how safe the coupon payments are expected to be from the bond. If the spread is wider than other bonds in its rating class, then the market is essentially assuming that the ratings agencies may downgrade the debt's repayment rating.

If all of this sounds a bit too complicated for you, then please stay with us here! Below you will find definitions of several key fixed-income terms that should assist you in your analysis of LQD:

Ratings agencies -- These companies provide a grade to each individual debenture issued by a company or government. The grade rates the likelihood that the bond will be paid off in full, with all of its coupon payments paid on time. There is a cutoff rating below which a bond is not considered investment grade, meaning there is a high risk that the company might default in its payments. When it comes to the grades given by ratings agency Standard & Poor's, bonds rated below BBB are not considered investment grade.

Time to maturity -- A bond's maturity is the date on which the company must pay back the face value of the bond. Depending upon how the bond's payments are structured, this face value might be more or less than what you initially paid for the bond.

Coupon rate -- This is the annual coupon rate based on an issuance price of $100. If you hold a bond with a 7% coupon, then for every $100 face value of the bond, you will receive $7 per year in interest. (FYI -- It is very unlikely that you will ever pay exactly $100 for an outstanding bond, as prices fluctuate from moment to moment based on the current interest rate environment.)

Most corporate bonds pay a coupon twice per year, so the coupon rate is double the semi-annual payment. The term "coupon" is a historical one that derives its name from the time in which investors had to cut little coupons off the bottom of their bond and bring them to their local bank for redemption. In this day and age, this is now all done electronically.

Yield to maturity -- This is the mathematically computed yield you would receive if you held the bond to maturity. The calculation assumes you could reinvest your coupon payments at this same rate and that interest rates will not change between now and maturity.

Spread -- This is usually short for "spread to government-issued treasury bonds." It is a measure of how much higher the yield is for a given bond when compared to a like-maturity U.S. government issue. It is usually quoted in "basis points," with one basis point being equivalent to 0.01%. For example, if a U.S. Treasury with five years to maturity has a yield to maturity (YTM) of 3.22% and a five-year bond issued by ExxonMobil sports a YTM of 4.96%, then the spread is said to be 174 basis points (100 times 4.96 – 3.22). Yields are almost always higher for corporate bonds due to default risk. It is assumed that the U.S. government will not default on their U.S. dollar-based obligations. This is reasonable, since the Treasury can always print dollars to pay off its debt if need be.

The iShares Goldman Sachs InvesTop Corporate Bond Fund (LQD) invests a large proportion of its holdings in long-dated securities. In other words, the fund holds many bonds that do not mature for ten years or longer. In fact, the average time to maturity for the fund's holdings is roughly 10.5 years. This makes the price volatility fairly high (all other things being equal, the longer a bond's time to maturity, the more volatile its price will be) and similar to that of a 10-year Treasury note. Therefore, LQD is moderately more volatile than the 7-10 Year Lehman Treasury Bond Fund (IEF), but is less volatile than the 20+ Year Lehman Treasury Bond Fund (TLT).

Recall that prices of debt securities tend to move in the opposite direction of equities. This is not always true, but in recent years we've seen this negative correlation hold in a fairly consistent manner. This means that during periods of falling stock prices, investors will often rotate money out of stocks and into bonds. Typically, corporate bond funds underperform Treasury funds during such periods. This is because stocks usually fall during times of a weak economy. Although yields fall during such difficult periods, the default risk also rises, so spreads to Treasuries tend to widen. When spreads widen, corporate bonds underperform like-maturity Treasuries.

In 2002-2003, yields fell very sharply. There was a huge search for higher yields. This allowed yield spreads to narrow despite concerns regarding the economy's health. But if interest rates rise from here, then spreads may widen as well. Therefore, the current risk in corporate bond funds is much higher than normal. It also means that if the economy unexpectedly slows, spreads could also widen by a greater margin than in the past.

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