As of late, the usually dull and boring world of high quality corporate bonds has been anything but.

In case you haven’t noticed, exchange-traded funds (ETFs) following investment grade corporate bond indexes have been swinging all over the place.  

In just two days, the iShares iBoxx $ Investment Grade Corporate Bond ETF (AMEX: LQD) dropped 15%, as low as $85.05. By the end of last week, LQD recouped almost 10% and closed at $ 92.70

To give you some perspective how dramatic that type of move is LQD has fallen harder and faster than the Dow Jones Industrial Average and S&P 500! If you’re a conservative bond investor, this isn’t exactly what you thought you ordered.

Volatility of this nature is highly unusual for investment grade bonds, which are supposed to represent the highest quality segment of the corporate debt market. Then too, these are unusual times.

Peeking Beneath the Hood

A closer look at LQDs underlying holdings reveal bonds from companies like American International Group (NYSE: AIG), Lehman Brothers Holdings (NYSE: LEH), and a number of other beleaguered financial companies.

In the case of AIG and Lehman, their financial condition deteriorated so suddenly, major rating agencies like Moody’s and Standard & Poor’s couldn’t downgrade all of their corporate debt fast enough. When Aaa/AAA debt becomes junk overnight, even rating agencies, in all their glory, are held hostage to the forces of the financial markets, which move faster and swifter. And that’s how investment grade bond funds can sometimes end up getting stuck with radioactive corporate debt.

But other factors are at work.

Even though LQD is supposed to track the highest quality corporate bonds, its index of just 100 holdings is much more concentrated compared to other bond ETFs. This leaves it vulnerable to the sort of volatility we’ve recently seen. Any future implosions in the corporate grade bond market could lead to further declines in LQD.

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Another interesting point is the near identical year-to-date performance of investment grade debt compared to junk debt. The iShares iBoxx $ High Yield Corporate Bond Fund (AMEX: HYG) is down 19.2 percent, which isn’t much more than the 15.4 percent fall in LQD. When quality grade corporate debt is performing like junk, you know that confidence in corporate bonds is low. The current yield on LQD is around 6.5 percent compared to a 10.30 percent yield for HYG.

Safety in Numbers

For bond investors that want to steer clear of the volatility and shakeup (or shakedown, depending on your perspective) that’s happening in the corporate debt universe, stick with broadly diversified bond funds.

Whereas LQD contains just 100 of the most liquid bond issues, the iShares Lehman Credit Bond Fund (NYSEarca: CFT) has roughly 3,300 bonds within its underlying index. Put another way, each ETF attempts to capture the same investment grade bond market, but different segments. CFT aims to track the full universe, whereas LQD focuses on the more heavily traded or liquid part. 

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Another excellent choice for a core bond position is the Vanguard Total Bond Market ETF (AMEX: BND). The fund follows a broad mix of investment grade bonds including Treasuries, corporate, mortgage-backed, asset-backed, and international dollar-denominated issues. All bonds have maturities of 1 year or more and are rated Baa3 or above by Moody's. The same holds true for the more popular but less diversified iShares Lehman Aggregate Bond Fund (AMEX: AGG). 

BND and AGG have declined by just around 0.8 percent this year and carry a yield in the vicinity of 4.5 percent.

Building on a Solid Foundation

If you’re trying to construct a solid foundation for the fixed income portion of your portfolio, there’s no better place to start than with bond index funds and ETFs. In any given year, the vast majority of active bond fund managers will underperform major bond indexes. Of course, they don’t want you to know that, but you should.

If you’re relying on a portfolio manager to save you from Wall Street’s latest crisis, think again. It remains to be seen if bond stars like Bill Gross of Pimco and a handful of others will be able to dodge the carnage we’re currently witnessing in the bond market. Many fund managers have been tricked into buying depressed debt that’s gone from half price to zero.

Lastly, the cost of owning index bond funds much lower compared to actively managed bond mutual funds. According to ETFguide.com, the average annual expenses for broadly diversified bond ETFs are just 0.17 percent. This means you get to keep more of your dividend income where it truly belongs; in your own pocket!

Do yourself a huge favor and follow the lead of other wise investors. Stop second guessing yourself and take advantage of what bond ETFs have to offer. Choose wisely!