Fixed Interest: holding bonds directly versus a bond ETF
Fixed Interest: holding bonds directly versus a bond ETF

Events of the past several weeks have helped convince markets that a long period of extremely low US short-term interest rates might finally be coming to an end. On 3 February 2018, US employment data showed stronger than expected wage growth, leading to increased fears of inflationary pressures building in the US economy. At the same time, Congress approved hundreds of billions of dollars in tax cuts and spending increases, at a time when inflation and wage growth suggest that the economy is already heating up.

As a result, investors increasingly expect the Federal Reserve to tighten monetary policy, with the futures markets implying at least three 0.25% rate rises this year, taking the central bank’s short-term interest-rate target to 2% by December 2018.

The expectation of increases to short term interest rates, combined with rising inflationary expectations, also resulted in the long end of the yield curve shifting upwards, with the benchmark US Treasury Bond yield rising from 2.41% at the start of the year to a four year high of 2.96% in February, a 55 basis points rise (bonds sold off). The Australian 10-year government bond yield increased in line with the US market lead, rising 29 basis points from 2.63% to 2.92%, over the same period.

The higher yield to maturity (YTM) now available on bonds is creating an opportunity for investors to review and assess the universe of fixed interest investments available in the Australian financial markets.

Within the ASX, investors can invest in: 

  • Australian Government Bonds
    • Listed in 2012, can be bought in $100 units. 
  • Fixed Income exchange traded funds (ETFs) 
    • Listed in 2010, over a portfolio of fixed income securities based on an underlying bond index, with no minimum investment. 
  • Exchange Traded Bond units (XTBs) 
    • Listed in 2015, over individual corporate bonds from the top 50 ASX listed companies, can be bought in $100 units.


 

Many investors assume that bond ETFs are similar to equity ETFs, which provide broadly similar investment outcomes to holding the shares directly, with the added bonus of diversification. However, we would contend that bond ETFs do not provide investors with the best way to achieve a fixed income exposure for their portfolios, for the following reasons:

 

Predictability

The key reason investors choose bonds is predictability; bonds have two predictable attributes, in the absence of default by the bond issuer.

Firstly, bonds have a fixed, unchanging date when they mature, at which time investors are repaid the principal. Investors know both the value and date when the bond will be repaid.

Secondly, bonds pay regular coupons – again, a set amount on a set date. You can buy a bond with a fixed rate of return – or yield – at the time of purchase. This yield is the annual return on your investment until the bond matures, or you sell the investment.

However, bond ETFs are not predictable, because they don’t mature. Instead they have a measure called the ‘average maturity’, which is the weighted average of the maturities of all the bonds in its portfolio. At any given time, some of these bonds may be expiring. By putting maturing bonds into non-maturing funds, different outcomes are achieved, with a loss in predictability as all bonds in the ETF must be replaced by bonds yet to be issued.

Some ETFs hold 100-400 bonds, so replacement is frequent. A manager can’t know what’s going into the portfolio because nobody knows what bonds will be issued in the future.

When outcomes are compared, a bond held equals predictability – this is the hallmark of bonds and a key reason for ‘fixed income’ in the first place. But with ETFs, investors can’t know the future income, while future market prices are unknown.

Interest rates rises

Interest rates in Australia and global markets are at historical lows and some central banks have already started increasing rates, with others set to follow suit as inflationary pressures continue to build, given synchronised global economic growth. While the timing can’t be predicted, the direction of rate movements is most likely up, likely resulting in an increase in yield to maturity on bonds.

As yields increase, the differences between individual bonds held versus bond ETFs become most obvious. A bond can be held to maturity and the principal paid back, regardless of interest rate moves. Market prices are sensitive to interest rates; when rates increase, the value of bonds generally fall. Hence, selling bonds in this environment can lead to losing money on your initial investment. With individual bonds, investors can mitigate this risk by holding the bond until maturity; however, since bond ETFs don’t mature, rising rates can cause a drop in a bond ETF’s unit price at the time the principal is required.

Control

Investments in individual bonds provides investors with the ability to decide which bonds are held in the portfolio. Selection might be based on matching cash flows with income needs, investing in bonds from companies or sectors where the investor has no equity exposure, thereby diversifying their portfolio, or based purely on yield. Investors might also choose to buy a bond or not, based on ethical or environmental concerns.

On the other hand, by investing in a bond ETF that simply tracks an index, the future yield is unknown, and distributions can change month to month, making it much harder to match cashflows with income needs.
 

ASX - listed Australian Bond ETFs 12 Month Absolute Returns Annualised Volatility
iShares Core Compusite Bond ETFs (IAF) 3.3% 2.3%
Vanguard Australian Fixed Interest ETF (VAF) 3.2% 2.1%
Vanguard Australian Corporate Fixed interest ETF (VACF) 5.1% 3.0%
 
ACBC Model Portfolios 12 Month AbsoluteReturns Annualised Volatility
Concentrated High Yield 7.5% 1.6%
High Yield 7.0% 1.5%
Maturity Ladder S1 6.3% 1.1%

Source: Australian Corporate Bond Company. Bloomberg, Patersons Research.
 

A critical point to remember

Bond ETFs advertise their historical returns. Individual bonds can, in the absence of a default, tell you your future returns. The latter provides the predictability for which bonds as fixed interest investments have been long known and valued.