SCHI: Corporate Bonds Could Still Avoid Credit Risk (But Not For Long)

I continue to believe that corporate credit risk is mispriced. Then again, I’ve believed that for over 6 months. So maybe I’ll be wrong further. And if I am, then there’s an argument to invest in funds like the Schwab 5-10 Year Corporate Bond ETF (NYSEARCA:SCHI), which represents an investment in the intermediate-term corporate bond market. SCHI is a fund that is passively managed. It is designed to track the Bloomberg US 5-10 Year Corporate Bond Index. This index tracks the corporate bond market within the US, and it specifically covers corporate debt securities with remaining maturities of between 5 and 10 years. SCHI’s underlying index follows a rules-based strategy that is designed to provide investors with an economic representation and a transparent exposure to the corporate bond market within this maturity range.

By far, the biggest advantage of SCHI is its expense ratio, weighing in at just 0.03%. That is remarkably low compared with many active funds, as well as a growing number of exchange-traded funds that track the same categories. Maintaining a high percentage of a fund’s return is a big deal. Small differences in cost ratios accumulate over time. You get to keep more of your gain per unit of time if your fund costs less to administer and maintain. Also, SCHI’s ETF wrapper is arguably a tax advantage. Because some mutual funds distribute realized capital gains to shareholders, usually annually, SCHI’s ETF wrapper should limit both the frequency and magnitude of capital gains distributions. This trait can be especially attractive to taxable-account holders of SCHI, who should pay less tax because of it.

ETF Holdings: A Closer Look

No position makes up more than 0.35% of the fund. This is highly diversified given the weightings and sheer number of holdings overall. The implication here is that even if my concerns around credit risk are ultimately correct, there’s solid diversification within the fund to mitigate it.

Sector Composition

SCHI’s sector exposures are dominated by Industrials and Financials, with Utilities last. No surprises here. The Industrials side of the marketplace has fared quite well in this cycle, so the 54.28% weighting has clearly worked, as Financials also perform decently here. In the event of a global downturn and slowdown, though, these two sectors in particular, I suspect would suffer disproportionately.

Peer Comparison

The main fund to compare SCHI to is the iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD) which is a broad corporate bond ETF, holding many different bonds of all maturities. It gives exposure to the entire US investment-grade corporate bond market as a whole. Looking at the price ratio of SCHI to LQD, we find that SCHI has moderately outperformed. Overall, a good choice.

Evaluating the Investment Thesis

On the positive side? The yield. It’s at the upper end of the historical range (no surprise given where rates are). The intermediate-term focus of SCHI’s holdings in corporate bonds should net higher yields than those found in the market for shorter-term bonds, while eliminating a bit of the interest-rate risk present in longer-term bond funds.

Another positive? High diversification. SCHI buys a basket of corporate bonds, providing diversification benefits and aiding in the minimization of idiosyncratic risks associated with individual issuers. And if you want liquidity and transparency, go for an ETF such as SCHI, rather than buying individual bonds.

The downside? The bonds in which SCHI invests – investment-grade corporate bonds – carry more credit risk than bonds issued by governments, as their value is dependent upon the financial viability and strength of the companies that issue them. It’s also sector concentrated with the focus on Industrials and Financials, both of which are highly cyclical.

Conclusion: A Strategic Choice for Intermediate-Term Corporate Bond Exposure

For investors who want to own a low-cost, tax-efficient, easily traded, effective way to gain exposure to the intermediate-term corporate bond market, the Schwab 5-10 Year Corporate Bond ETF is a good choice. I just personally wouldn’t consider it here for a long-term investment, given credit risk I believe continues to be mispriced in the marketplace. That doesn’t mean you should avoid it, but as with any investment, it’s worth doing the homework and thinking about where we are in the cycle. Good fund overall, though.

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