Investing for income simpler with new ETFs

Photo of Stephen Howard By Stephen Howard

min read

Bonds offer lower risk with diversification benefits.

The new financial year can be a great time to take stock of investment portfolios as we review our personal finances more broadly and count our profits and losses.

Looking ahead to next financial year, it is likely that not much will change for the long-term outlook – investor sentiment will probably remain uncertain and cautious, and market conditions in Australia and abroad are likely to continue to be more fragile than everyone would like.

This poses a problem for many Australian investors, who have become accustomed to high-yielding domestic shares and the sweetener of franking credits. Large locally listed corporates that have long paid handsome dividends are now likely to tighten their belts in a more uncertain business environment.

Although chasing yield is a common course when faced with the prospect of lower returns, it is important to consider downside risk alongside potential yield when it comes to setting your asset allocation.

This is where fixed-income exchange-traded funds (ETFs) come in, offering a simple way to tap into diversified bond funds, which typically offer regularly paid income, positive performance when equity markets fall, and a lower-risk profile compared to shares.

Although bonds tend to offer lower long-term returns than equities – Vanguard modelling forecasts 2.5 to 3.5 per cent for bonds and 7 to 10 per cent for equities over the next decade (2016 Vanguard Economic and Investment Outlook) – bonds also have a lower-risk profile and generally offer diversification benefits, particularly when equity markets tumble and yield is hard to come by.

How fixed-income ETFs work

Fixed-income ETFs invest in bonds – that is, debt issued by a government, statutory body or large corporate. Bonds have a set shelf life or maturity, and over their life make regular interest payments at a fixed rate (coupon rate), and repay the amount they were issued at (face value) when they mature. Unless, of course, the issuer happens to default somewhere in between.

ETFs may also buy and sell bonds in the over-the-counter markets as needed, where the market price will vary depending on how appealing the face value and coupon rates are compared to the risk profile of the issuer of the bond and the security at hand.

As with all ETFs, these funds can be traded on ASX through a broker, they track an established market benchmark and have a transparent basket of holdings.

An example might be a diversified Australian bond ETF, which tracks the performance of a benchmark such as the Bloomberg Ausbond Composite 0+ Yr Index, which includes bonds issued by the Australian government, state governments, statutory authorities and investment-grade corporations.

The ETF would track the collective performance of this index by holding a representative sample of this collection of bonds, holding more or less of a certain security depending on what risk characteristics the holding produces relative to the structure of the index.

The collective holdings will pay their coupon rates over time until they mature, with the fund reinvesting both coupon receipts and the face value proceeds in new or pre-existing bonds.

In this way, a fixed-income ETF is much the same as a traditional managed fixed-income fund that tracks an index. The key difference is that the ETF route provides easy access to a diversified basket of bonds if you are already familiar with trading on ASX.

Know what you are getting

Fixed-income ETFs may include bonds from various types of issuers, and it is important to know what these are and how their risk-and-return profiles differ.

We can broadly divide bonds into three groups.

1. Government bonds

They are debt securities issued by government bodies, typically treasuries. Bonds issued by national governments typically have the lowest risk, given governments can use steady tax revenue to make interest payments. However, government bonds tend to also promise the lowest level of expected returns as they tend to offer a low level of risk exposure.

The main risk for government bonds is interest rate risk. Government bonds tend to have long maturation dates, which means they can be more affected by interest rate movements. As interest rates fall, the coupon rate on existing bonds may look more attractive than those being issued in lower-rate environments, so their value increases in the short term.

Conversely, when interest rates rise, values may fall in the short term as investors look to bonds issued with a higher coupon rate. If you consider that government bonds may last as long as a decade, there would be many points in those years when interest rates might change and affect the short-term valuation of the security.

It is important, however, to consider that if an investor holds the securities for the long term they can expect to receive a long-term rate of return that is consistent with the yield to maturity at the time of their investment.

2. Corporate bonds

These are inherently riskier debt securities issued by large companies, which use bonds to raise capital alongside other securities, such as shares. These organisations could range from large banks to resource companies.

Interest rate risk remains a concern in this case, but it is a slightly lower concern for corporate bonds because they typically have a shorter maturation and therefore tend to be less affected by interest rate movements than longer-term bonds issued by governments.

The main risk corporate bonds face is credit risk, which reflects the greater likelihood that an issuer might default on payments. Corporate bonds offer potentially higher income than government bonds, but corporate issuers rely on commercial, rather than tax, revenue, which can be disrupted by competitive business conditions.

3. Government-related bonds

These are issued by organisations that are not strictly government bodies but have ties to government. These issuers could range from large supranational organisations such as the World Bank, to government-owned state power companies and state government borrowing authorities such as the Treasury Corporation of Victoria or the New South Wales Treasury Corporation.

The risk profile for government-related bonds varies, given their assets are not secured directly by governments and these bodies often rely on self-generated revenue to make interest payments. In this way, government-related bonds often sit somewhere between government and corporate bonds in terms of risk-and-return profiles.

Including fixed income in your portfolio

When it comes to choosing fixed-income ETFs, it is important to recognise that different funds will hold varying blends of government, government-related and corporate bonds, which means they will have different risk-and-return profiles.

For many investors, a diversified bond fund will be the simplest choice. With a single trade, you can buy units in a product that tracks the Bloomberg Ausbond Composite 0+ Yr Index, which would be a conservative and reliable income generator.

However, Australian investors can also tailor their fixed-income exposure thanks to a wave of new ETFs in recent years, allowing them to fine tune their risk-and-return profiles.

For instance, last year we saw the first international fixed-income ETFs join the Australian market: the Vanguard International Fixed Interest ETF (ASX code: VIF), which holds global government bonds, and the Vanguard International Credit Securities Index ETF (ASX code: VCF), which holds global corporate and government-related bonds.

This was a significant development, as international diversification is hugely important in spreading a portfolio’s fixed-income risk, and until then had only been accessible through non-listed managed funds.

This year, investors have a new Australian corporate bond ETF choice, the Vanguard Australian Corporate Fixed Interest ETF (ASX code: VACF), which offers potential for higher income than Australian-government bond funds.

Investors can now build a nuanced fixed-income exposure using ETFs, which, at the lower end of the price spectrum cost around 0.20 or 0.30 per cent in management expenses each year.

As with any asset allocation decision, it is essential that investors weigh up their risk tolerance against their appetite for returns as they determine what mix of fixed-income products will best meet their investment objectives.

About the author

Stephen Howard is Head of Fixed Interest at Vanguard, where he oversees the management of all fixed-interest, cash, currency hedging, multi-asset and investment solution mandates.

Follow on Twitter: @vanguard_au

From ASX

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