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Scoring Versus Rating in Fixed Income ETFs

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THE REALITY IN TODAY’S FIXED INCOME ENVIRONMENT

Several years of global central bank intervention and regulatory change have created opportunities for fixed income product innovation. Aided by new sources of bond data, improved quantitative models and the recognition that the traditional sources for credit information – nationally recognized statistical rating organizations (NRSROs) – may not have kept up with the times in the fixed income credit sector and we believe that investors are looking for a contemporary approach to credit evaluation.

It is in this environment that we introduced our proprietary FlexShares Corporate Bond Credit Scoring Model to produce two truly innovative corporate credit ETFs - FlexShares Credit-Scored U.S. Corporate Bond Index Fund (SKOR) and the FlexShares Credit-Scored U.S. Long Corporate Bond Index Fund (LKOR).

UTILIZING ECONOMIC ANALYSIS TO JUDGE BOND ISSUERS

Until the economic crisis of 2008, many investors relied on the ratings provided by the NRSROs to help make the full determination of credit worthiness of an individual bond issuer. In recent years, however, we developed a quantitative model that we believe helps identify and respond to changing issuer/industry information and shifting macro environments.

Management Efficiency

Profitability

Solvency

Developed in collaboration with the quantitative research group within Northern Trust Asset Management, we believe the FlexShares Corporate Bond Credit Scoring Model is a fully objective credit evaluation process that allows us to construct innovative corporate credit indexes, with little reliance on NRSRO ratings. Instead the model evaluates debt issuers based on economic analysis such as management efficiency, profitability and market solvency, which are then sorted and ranked within five macro industry sectors. The model produces credit evaluations that we believe update with greater frequency and specificity than NRSRO credit ratings when measured against future credit spread and bond price movements.

The model also addresses potential corporate bond liquidity challenges by optimizing a carefully selected subset of all credit issuers from which illiquid, orphaned and small lot names have been removed. Then, multiple factors are taken into account including the characteristics of issuers' total debt structure, minimum exposure percentages and odd-lot trade restrictions, to aid in developing our corporate bond indexes.

AN INVESTIBLE BENCHMARK

Legacy corporate credit indexes reflect the composition and characteristics of the broad corporate bond market but we believe they fail to provide readily investible benchmarks that serve the needs of investors. FlexShares' SKOR and LKOR funds offer a rules-based credit scoring methodology that enables our corporate bond index funds to efficiently replicate the legacy credit index's exposures while taking into account ever changing economic and business changes.


*A credit spread is the difference in yield between two bonds of similar maturity but different credit quality.


FIND OUT MORE

The FlexShares approach to index-based investing is, first and foremost, investor-centric and goal oriented. We pride ourselves on our commitment to developing products that are designed to meet real-world objectives for both institutional and individual investors. If you would like to discuss the attributes of any of the ETFs discussed in this report in greater depth or find out more about the index methodology behind them please don't hesitate to call us at 1-855-FlexETF (1-855-353-9383).