Bonds are an enormous investment category, but investors often have to accept one of two related drawbacks with fixed income investments. Bonds where repayment is not an issue (like U.S. government securities) offer very low yields, while higher-yielding bonds like corporate debentures offer significantly greater repayment risk. Covered bonds are something of a “middle ground,” offering a much more secure credit profile than corporates, but also higher yields than government securities. Now investors can take advantage of an ETF that focuses on these fixed income securities: the ProShares USD Covered Bond ETF (COBO, B) [see How To Pick The Right ETF Every Time].
COBO seeks to replicate the BNP Paribas Diversified USD Covered Bonds Index, which is an index of U.S. dollar-denominated covered bonds. Covered bonds are a type of fixed income security, often issued by financial institutions, that uses a pool of assets (typically mortgages or other loans) to “cover” the bond or add further assurances that investors will recover their principle in the event of a default or severe financial stress at the issuing business. In that respect, covered bonds are vaguely similar to bonds with sinking funds or equipment trust certificates; in these cases, there are earmarked assets on hand to back up the credit of the issuer.
Covered bonds are relatively uncommon in the United States, and while the individual securities included in the index (and fund) are U.S. dollar-denominated, the vast majority of issuing institutions are located outside the United States [see Covered Bond ETFs: Everything You Need To Know].
The ProShares USD Covered Bond fund began trading in May of 2012, but has accumulated less than $7 million in assets under management as of January 2013. The fund’s trading liquidity is also quite limited.
What Makes COBO Unique
While there are a limited number of bond ETFs that focus on other specialty fixed income types (including convertibles, Build America Bonds and high credit quality), COBO is the only fund focused on covered bonds. Likewise, while covered bonds are similar in some respects to mortgage-backed or asset-backed securities, the loans in the pool(s) are not securitized, remain on the bank’s balance sheet, and there is not a direct flow between the interest and prepayments in the pool to the bondholders.
How It Fits in a Portfolio
COBO’s underlying index focuses on exceptionally high-quality (typically AAA) bonds, which makes COBO appropriate for more conservative investors who do not want higher credit risks. Because of the high credit quality and low effective duration, the yields on the bonds owned by COBO (and thus the yield for COBO itself) are relatively low. This makes COBO appropriate for investors looking for enhanced yields on high-quality bond portfolios, but less appropriate investors who seek higher yields and are willing to incur higher risks [see 8% Yield ETFdb Portfolio].
What It’ll Cost You
At 0.35%, COBO’s expense ratio is on the high end of similar bond funds (mortgage-backed security ETFs), where expenses range from 0.15% to 0.35% and average 0.26%. COBO is not available for commission-free trading.
Under The Hood
The market for U.S. dollar-denominated covered bonds is still relatively small, which means there are relatively few holdings for the underlying index and for this fund to select. As of the beginning of the year, the fund held fewer than 50 positions, with roughly 30% of the fund’s assets devoted to its top 10 holdings.
There have been minimal covered bond issuances from U.S. firms, and more than 40% of the fund’s assets are held in bonds issued by Canadian firms. Corporations in Australia and Switzerland also both make up more than one-tenth of the fund’s holdings. Virtually all of the bonds held in this fund are issued by banks or bank-like institutions [see COBO's Fact Sheet].
Because of the high credit quality, coupon rates on these bonds are low, and nearly 90% of the bonds in the fund have coupon rates of 3% or below, with nearly 40% offering rates below 2%. Half of the fund’s assets are in bonds with maturities of three to five years, and another third are in the one-to-three year category. That leads to a low modified duration of nearly three years for the fund.
Yield, Volatility and Performance
COBO’s 30-day SEC yield is 0.50% and distributions are made on a monthly basis.
Due to the short operating history of the fund, there is too little performance and volatility data to make useful comparisons to other funds or benchmarks [see COBO Realtime Rating].
Given the similarity between covered bonds and mortgage-backed securities, ETFs specializing in mortgage-backed securities (MBS) are arguably the most relevant alternatives for investors considering COBO shares [Download 101 ETF Lessons Every Financial Advisor Should Learn]:
- (MBB, A): The iShares Barclays MBS Fixed-Rate Fund is the largest MBS ETF, with over $6 billion in assets. MBB charges a similar expense ratio (0.31%), but offers a much higher yield (30-day SEC yield of 2.59%) and is considerably more diversified (over 360 holdings).
- (VMBS, A+): The Vanguard Mortgage-Backed Securities Index Fund is a lower-cost option for investors who want exposure to investment-grade MBS. VMBS charges an expense ratio of 0.15%, and offers a very diverse portfolio (over 1,000 holdings), but a low yield (30-day SEC yield of 0.28%).
Disclosure: No positions at time of writing.