The case for fixed-income ETFs

Bond ETFs offer a cost-effective and convenient means to diversify a portfolio and potentially reduce overall risk through holding fixed-income securities. Robert Stephens explains.

 The case for fixed-income ETFs

A fixed-income ETF seeks to track the performance of a specific index of bonds. In doing so, it provides investors with a cost-effective and simple means of obtaining exposure to a wide range of bonds.

Due to a potential lack of liquidity in some of the issues within a bond index, a fixed- income ETF often invests in a representative sample of bonds within the index that it is aiming to replicate. Through buying the largest and most liquid issues within a bond index, a fixed-income ETF may provide investors with enhanced liquidity while it tracks the index.

What is a bond ETF?

As its name suggests, a fixed- income ETF (or bond ETF) is traded on an exchange. This can mean that investors have greater flexibility to decide when to buy or sell when compared to a mutual fund that invests in bonds. Unlike a mutual fund that typically trades once per day, investors in a bond ETF can buy shares in the fund at any point during the exchange’s opening hours through their online share-dealing provider.

Bond ETFs can be bought and sold in quick succession, with there being no minimum holding period. This may provide investors with greater flexibility when compared to buying individual bonds, with many corporate issues having no active secondary market.

Since fixed-income ETFs trade on an exchange, they offer greater price transparency regarding their holdings than may be the case with mutual funds or individual bonds.

When purchasing a fixed- income ETF, investors usually pay a standard commission charge levied by their share-dealing provider, as well as an ongoing management charge levied by the bond ETF itself. As with many funds that seek to track an index, the charges from a bond ETF may work out to be lower than buying a diverse range of individual bonds within a portfolio. They may also be more competitive than a mutual fund that invests in fixed-income securities due to lower expenses incurred in running the fund.

Bond ETFs can trade at a premium or discount to their net asset value. This depends on the relationship between supply and demand at a particular point in time, with arbitrage helping to keep a fixed-income ETF’s price in line with its NAV in the long run.

Fixed-income ETFs have bid/ ask spreads, with investors buying at the latter and selling at the former. The bid/ask spreads of bond ETFs can be relatively wide – especially for less liquid ETFs. This can increase the overall cost of owning a bond ETF, and should therefore be considered by an investor prior to purchase.

Related: Euro government bond ETFs offer low cost option for investors

While individual bonds usually have a semi-annual coupon (or interest payment), fixed-income ETFs may make distributions to their investors on a more frequent basis. This is often monthly or quarterly, and may therefore provide investors with a more regular income.

As with any fund that seeks to track an index, bond ETFs may display tracking error. This is when returns from the fund do not perfectly match those of the index, with costs potentially further reducing total returns.

Why would investors use bond ETFs?

Investors may wish to gain exposure to bonds for a variety of reasons. For example, they may desire a regular income from their capital, or they could be seeking to diversify their portfolio away from shares and other mainstream assets.

A bond ETF could be a sound means of achieving that goal. It is a very accessible product, since there is no minimum investment size. This could make it particularly attractive to smaller investors who may not have sufficient capital to make it worthwhile holding a variety of different bonds within their portfolio.

Not only does a bond ETF cut costs for many investors compared to holding a large number of individual bonds, it is also less time intensive. For example, investors in a bond ETF may avoid the extensive credit research that is required when purchasing individual bonds. Likewise, they are not under pressure to find new bonds to replace the ones within their portfolio that have matured.

A bond ETF will continually update its holdings as new bonds are added to the index which is being tracked. Therefore, an investor looking for an income from long-dated corporate bonds, for example, can simply buy the appropriate fixed-income ETF and pick up a regular income without being required to actively manage their portfolio.

A bond ETF is likely to be more liquid than many individual bonds. This is particularly the case among corporate bonds, with many of them not having active secondary markets. Investors holding such bonds may find it difficult to find a buyer should they wish to sell before the maturity date. Therefore, investors who desire flexibility in terms of when they can sell may find that easier when using a bond ETF.

Liquidity may be particularly relevant for investors who have focused on equity markets, rather than fixed-income markets, in the past. Equities, unlike bonds, generally have an active secondary market (unless they are very small businesses), which makes them easy to sell whenever an investor wishes.

Bond ETFs may provide a comparable investor experience to equities in this regard, thereby making them a logical first step for equity investors who desire fixed-income exposure within their portfolio.

Although bonds are generally viewed as being lower risk investments than equities, there are occasions where companies default on their debt. This means that diversification is just as important in the fixed-income market as it is in equities.

Are bond ETFs worth buying?

charges and generally lower ongoing expenses could make it a more cost-effective option for investors. Likewise, the cost to purchase a wide range of individual bonds in order to diversify and reduce overall risk could make the process prohibitively expensive for many investors.

A bond ETF’s relatively low costs are particularly relevant when the present-day returns on fixed income securities are taken into account. While equities may offer annualised total returns of 7-9% over the long run, the lower-risk nature of bond investing means that investors may obtain a significantly lower total return over the long run.

As such, even a 10 or 20 basis point difference in cost between a bond ETF and a mutual fund, or even between two different fixed- income ETFs, can have a much greater impact on an investor’s total returns than would be the case when comparing two different equity funds.

Investors in bond ETFs should be aware of risks such as tracking error and the potential for the fund’s price to deviate from its NAV. Furthermore, bond ETFs provide investors with less choice than if they sought to create their own portfolio of fixed-income securities.

However, this is a weakness that can be applied to any fund that seeks to track an index within any asset class, and is highly dependent on the requirements of an individual investor. For many private investors, the diversity, cost and convenience of a bond ETF is likely to outweigh its lack of customisation options. As such, bond ETFs are likely to be appealing when compared to other means of gaining exposure to fixed income securities.

Of course, a decade of ultra-low interest rates means that the returns currently available across the fixed income universe are relatively low. It may be challenging for investors to obtain a significant real-terms return on their capital after all costs associated with buying and selling a bond ETF are taken into account. This may reduce the appeal of the wider fixed-income market for income-seeking investors who would historically have held a significant proportion of their portfolio in bonds.

As such, investors who are seeking to generate an income on their capital may be better served by the stock market. A range of FTSE 350 shares currently have dividend yields that are significantly higher than those which are available on government bonds and on a substantial proportion of corporate bonds. Although stocks are riskier than bonds, the return differential in the long run could make them appealing for long- term investors.

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