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Cash Flow Emphasis Bolsters This Corporate Bond ETF

June 15, 2016 3:41 pm
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Cash Flow Emphasis Bolsters This Corporate Bond ETF

A simple view of investment-grade and high-yield corporate bonds is these are instruments sold to investors who, in most cases, are not looking to take on significant. Hence why creditworthiness is an integral part of evaluating corporate bonds.

After all, investors in these bonds not only want income, but their principle back as well. So, it pays to know a company's ability to generate free cash before jumping into its bonds. However, traditional corporate bond exchange-traded funds weight be size of issue, the equivalent of market cap weighting in equity ETFs, not by issuers' ability to generate cash.

The newly minted WisdomTree Fundamental U.S. High Yield Corporate Bond Fund (BATS: WFHY), which debuted in April, takes a different, eschewing issue size in favor of a focus on free cash flow capabilities.

Making A Difference With A Different Focus

The WisdomTree Fundamental U.S. High Yield Corporate Bond Fund follows the WisdomTree Fundamental U.S. High Yield Corporate Bond Index, which only includes high-yield corporate debt “with at least $500 million in par amount outstanding and a remaining maturity of at least one year,” according to WisdomTree.

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Obviously, investors embrace junk bonds because of the tempting yields which translate to superior income opportunities. However, as the old adage goes, there is no such thing as a free lunch in financial markets, and for the reward of those high yields, junk bonds have higher credit risk. The big risk for high-yield corporate bond investors is that an issuer defaults and declares bankruptcy, leaving bondholders with pennies on the dollar, if they are lucky.

That concern underscores the importance of WFHY's free cash flow (FCF) approach.

Cashing In On Cash Flow

“If you think about it, a large majority of companies in distressed situations often got there because of cash flow problems. Companies with inadequate or negative free cash flow (FCF) find themselves constantly under pressure to find the necessary resources to service their debts on time. If a leveraged business does not generate sufficient cash flow, its only other option may be to tap short-term revolvers, raise additional debt or equity, or generate cash via asset sales. With only a limited set of options, companies with sustained negative trends in cash flow may eventually become insolvent,” said WisdomTree in a recent note.

Although it is a high-yield ETF, WFHY does not present alarming credit risk as about a combined 83 percent of the ETF's holdings are rated BB or B. Additionally, WFHY features scant exposure to energy junk bonds, the sector responsible the bulk of high-yield defaults this year and last year.

“If an issuer has had positive FCF, on average, over the previous five years, it is eligible for inclusion in our Index. If cash flows turn negative, on average, over a rolling five-year period, that issuer is excluded from the Index,” added WisdomTree.