What happens to a target-maturity corporate bond ETF if one of the companies collapses?

Question

Consider a target-maturity corporate bond ETF such as the iShares iBonds Dec 2020 Term Corporate ETF (NYSE Arca: IBDL). The yield-to-maturity of the ETF is approximately 1%. The fund holds 250+ bonds from different companies. Suppose one of those companies collapses before the maturity of their bond. How is it going to affect the amount that I will get when the ETF liquidates in December 2020?

Suppose 1% of the holdings of the ETF is in a company that will later be bankrupt. Will that mean that the actual YTM of my investment will turn out to be 0% (or worse if there are multiple collapses)?

Answer 1

The ETF will get its proceeds from the coupons and redemption of the underlying bonds, so if some of the bonds default, then the ETF will not get the full proceeds (they may get partial proceeds depending on the rate of recovery) and the value will drop accordingly.

However, this is an investment-grade bond fund. The long-term default rate for these bonds is about 0.3% according to S&P. Plus, if a company is close to default, it most likely would be downgraded well in advance (barring some massive, unexpected drop in solvency that the ratings agencies miss), so their bonds would be sold by the fund before an actual default, reducing losses.

I'm not trying to say it can't happen, but the probability of it happening should be well under the 1% threshold to wipe out all profits.

Answer 2

If the value of the holdings of an ETF drops, then the value of the ETF drops. If the bond becomes worthless, this maximum loss would be reflected proportionately in the ETF's price. If it represented 1% of the value ETF then then the value of the ETF would drop by 1%. The YTM would also be reduced.