There seems to be an important investment asset that many Australians have forgotten. This particular asset has proven time and time again to have great diversification benefits and provide steady, reliable income.
What asset is this you may ask?
The name is Bond…Fixed Income Bonds, and much like 007’s martini cocktails, when markets are “shaken, not stirred”, bonds can be a valuable part of your portfolio.
In this article we’ll show you why and what we look out for when selecting a bond ETF.
What is a bond?
A bond (also known as fixed income) is a loan made by investors to a company or government. Bondholders lend money to the bond issuer for an agreed period (until maturity) and in return for that, they are paid a regular income in the form of interest.
At the end of the agreed period investors also receive their principal back. Historically Australian investors have preferred to invest in the share market, so bonds haven’t made it into most people’s portfolios.
According to SuperConcepts, self managed super funds (SMSFs) only have 12% of their portfolio in Bonds. This is incredibly low given the need for defensive income for those in drawdown and retirement phase, and a cushion to share market falls.
Bonds are considered by many to be boring, but at Stockspot, we believe that boring is brilliant!
Until recently it has been difficult for everyday investors to access bonds due to high minimum investment amounts, lack of diversification and costs. However, with the rise of Exchange Traded Funds (ETFs), investors now have a solution to easily access bonds and make them a part of their portfolios.
The growth of bond ETFs
Bond ETFs have started to enjoy strong growth over the last 5 years, growing at a rate of 5% per year to ~$13.3b and now make up 14% of the overall ETF market.
We believe this will continue to rise as ETF issuers release more bond ETFs, and investors demand more defensive assets to smooth out the returns from investing in shares.
Over the past 30 years, it is clear that when shares fall, high grade bonds do their job as a portfolio cushion and rise. Australian bonds were one of the few asset classes with a positive return in 2018 when share markets fell. Bonds were also the ballast that helped cushion the fall during the COVID-19 share market fall.
Whilst the actors playing James Bond may change overtime (Connery, Moore, Brosnan and Craig), bonds are resilient when share markets fall which has happened 6 times since 1990.
Bond ETFs offer a few key advantages over buying individual bonds:
Diversification – Bond ETFs hold a basket of bonds which improves overall portfolio diversification and reduces the chance of you lending a large amount to a dud company.
Transparent pricing – Bond ETFs are tradeable on the ASX whereas most individual bonds trade in more complex markets with pricing that is not very transparent and there are higher costs to getting in and out.
Performance – Bond ETFs track time-tested indexes, which continually do better than active bond fund managers. The 2019 SPIVA Report showed that 81% of active Australian Bond managers underperformed the index benchmark over 5 years.
Yield – believe it or not, dividends are not the only form of income you can get. Bonds can provide regular, consistent and predictable income, with less volatility than shares.
For more information about the basic of bonds as an asset class and the benefits they can provide, see our blog on Why Bonds Belong in Your Portfolio.
Bond ETF Road Test
Each year we compare all 200+ ETFs in our Australian ETF Report. Here we road test 3 Diversified Australian Bond ETFs:
iShares Core Composite Bond ETF (IAF)
SPDR S&P/ASX Australian Bond Fund (BOND)
Vanguard Australian Fixed Interest Index ETF (VAF)
We compare them across 5 factors:
IAF and VAF are the 2 largest Australian Bond ETFs managing $1.6b each. BOND has struggled to gain traction despite being listed at a similar time to its peer group.
This is likely due to a number of factors including BOND having higher costs, lower liquidity, less diversification (only holding ~120 bonds), and it tracking a less widely known benchmark.
When it comes to cost, the headline management fee (known as the Management Expense Ratio [MER]) is not the only thing investors should pay attention to.
Unfortunately, some ETF and Fund Managers bury all hidden costs in their Product Disclosure Statements. Think very tiny writing and lots of pages.
This is why it is important to consider the Indirect Cost Ratio (ICR), which incorporates all necessary transactional and operational costs to run the fund.
We also like to examine the slippage (buy/sell spreads) of each of the ETFs. This refers to how much you lose when buying/selling the ETF.
It is calculated as the average percentage difference between the best buyer and seller during market hours.
|ASX Code||Cost (Indirect Cost Ratio)||Buy/Sell Spreads (aka slippage)|
Source: ASX Fund Statistics December 2020
IAF has the tightest spreads at 0.03% followed narrowly by VAF with 0.05%. The slippage on BOND is 3 times it’s peers given its more concentrated holdings. Note: Bond ETFs during the COVID-19 crisis had their spreads widen from the market volatility. Importantly, it is not due to the ETF but due to the illiquid pricing nature of the underlying bonds themselves.
Blackrock recently reduced fees the iShares Core Composite Bond ETF (ASX: IAF) from 0.20% to 0.15% in April 2020, and is now the cheapest Australian bond ETF on the ASX. BOND is on the more expensive side charging 0.24% per year and incurring triple the slippage of IAF and VAF.
ETFs have 2 layers of liquidity – the liquidity of the ETF, and the liquidity of the underlying bonds within that ETF.
One measure of liquidity is measured by the average daily volume on the ASX. Volume is a measure of market making activity and trading interest which makes it a reasonable estimate of liquidity. IAF has the highest level of liquidity with an average trading volume of $7.2m, while VAF has ample liquidity at $4.2m per day.
Greater trading volumes make it easier to buy and sell an ETF and reduces the spread/slippage involved.
Performance track record
|ASX Code||1 Year Total Return||3 Year Total Return (p.a.)||5 Year Total Return (p.a.)|
The 3 Australian Bond ETFs have generated similar returns over the past 1,3 and 5 year periods. This is because they track a similar underlying portfolio of bonds.
Given the performance of the funds are likely to be similar, we place a greater importance on other factors when assessing these ETFs.
The longer a track record of an ETF and the index it mirrors, the better understanding you have of how an index reacts to different market conditions as well as how closely the ETF is tracking its index.
Also important is the ‘tracking error’ which measures how well an ETF does at mirroring its index.
|ASX Code||Index||Index History (Inception Date)||ETF History (Inception Date)|
|IAF||Bloomberg AusBond Composite 0+Yr Index||September 1989*||March 2012|
|BOND||S&P/ASX Australian Fixed Interest Index||October 2011||July 2012|
|VAF||Bloomberg AusBond Composite 0+Yr Index||September 1989*||October 2012|
*Bloomberg acquired UBS Australia’s Bond Indexes in April 2014, and subsequently rebranded. The original UBS index was created in September 1989.
|ASX Code||5 Year ETF Performance (p.a.)||5 Year Index Performance (p.a.)||Tracking Error|
IAF has the longest track record (albeit marginally), having been listed for over 7 years, and tracks the widely used Bloomberg AusBond Composite Index. It’s had strong performance since inception and also had low tracking error to its underlying index.
We look at a few others factors when selecting a bond ETF:
Duration – A measure of how sensitive a bond is to changes in interest rates. Bond prices and interest rates have an inverse relationship (i.e. when interest rates go up, bond prices fall).
Credit Quality – this is a measure of how likely a bond is to default (not pay its investors back). The scale ranges from the highest quality (AAA) to the lowest (D), with a rating of BBB- considered to be “non-investment grade” and is more risky.
For example, Australia has a rating of AAA whereas a country like Mozambique is rated D. The lower the credit quality, the higher the risk of defaulting. Bonds with worse credit quality tend to pay a higher interest rate to compensate investors for taking more risk.
Yield to Maturity – The rate of return an investor can expect if they hold the bonds until their maturity date. This does not factor in the price return, only the income return (known as coupon payments).
Bonds with shorter durations and better credit qualities provide a better diversification cushion when share markets fall. Poorer credit quality bonds can give you a higher yield but have a more similar correlation to shares so aren’t as helpful as a portfolio diversifier.
|ASX Code||Duration (Years)||Yield to Maturity (%)|
Source: ETF Product Provider as of 31 December 2020
James Bond chooses the Aston Martin as his choice of wheels. Stockspot adopts the same high quality approach when selecting a bond ETF. We’ve selected IAF for the Stockspot portfolios due to its size, liquidity, track record, high credit quality and relatively short duration.
It is an effective diversifier for the Stockspot portfolios due to its ability to cushion against share market volatility. Thanks to owning IAF and GOLD, all of the Stockspot portfolios had a positive return over the last year despite the share market downfall as a result of the coronavirus.
We also offer international bonds using the Vanguard International Fixed Interest Index (Hedged) ETF (ASX: VIF) as part of our Stockspot Themes range. VIF invests in a diversified range of high credit quality and income generating bonds issued by governments around the world (such as the USA, Japan, France and the UK).