The ins and outs of fixed-income ETFs

Christine St Anne  |  16/03/2012Text size  Decrease  Increase  |  

Christine St Anne: Earlier this year, the ASX changed its operating rules to allow fixed income ETFs to list. Now, new products have finally entered the market. To give us an idea about what these fixed income ETFs mean, I am joined by Morningstar's Tim Murphy.

Tim, welcome.

Tim Murphy: Hi, Christine.

St Anne: Tim, so can you give us an idea about these new fixed income ETF products?

Murphy: Sure. So there's been lots of talk in the market about this for quite some time now, but you know, the ASX has had to change its rule. It's been a long drawn-out process, but finally got there at the start of this year, and so now you've just seen BetaShares come to market with a cash ETF and now Russell and iShares on the same day both launched fixed interest ETFs tracking a range of different domestic indices.

So, it's really adding an extra piece to the puzzle. We've had equities and commodities and property-based ETFs to-date, and now you've got the sort of fixed interest and cash options as well, which really fill out the multi-asset range of ETFs you can now trade on the ASX.

St Anne: Tim, you mentioned indexes, so do investors need to be mindful of the different indexes these ETFs track?

Murphy: Absolutely. Like any ETF investment, your investment is - you're party to whatever the underlying constituents of that index are, and so looking specifically at the fixed interest ETFs we've seen launched. There's a mix of treasury or government security-only. There is some corporate-only, and then there is some, what we might call aggregate or combination of those two.

So, for instance, for example, the well-used Australian Bond Index, the UBS Composite, iShares has an ETF tracking that index, which is a combination of government, semi-government, and corporate issuance.

Then on the other side of that, say like Russell has launched both government-only and corporate-only as well. So, you've got myriad different options that have been launched in a space of just this week.

St Anne: Tim, investors have traditionally had access to fixed income products via managed funds. How do fixed income ETFs differ from these managed funds?

Murphy: Yes, so structural differences of an ETF versus a managed fund are no different for fixed interest as they are to equities or any other asset class. So, the key difference has been the ETF is obviously listed, traded on the exchange as opposed to a managed fund, which has a buy and sell with the NAV struck once a day. So, you are open to the vagaries of the market, but then also those structure and tax benefits that are applicable to the ETF structure are equally applicable here as well, whereas the managed funds structure you are more attune to being, suffering or benefiting from the tax consequences of other investors in the pooled unit trust, ETF tends to be a cleaner tax structure for investors.

St Anne: Delving a little more into the structure, Tim, how are things like capital appreciation and income yield distributed in these ETFs to investors?

Murphy: Sure. So, as with ETFs and distributions, it's really just a pure function of the underlying constituents of that. So, the ETFs will typically - as coupons in the case of fixed interest ETFs are paid out, they will collect those and then periodically distribute those and typically you will find that quarterly pay those out straight through. And generally speaking, the yield on the ETF will match the, sort of, weighted average yield of the underlying portfolio.

That's slightly different to a managed fund distribution where the yield on the underlying constituents is one element of it, but certainly flows in and out of the managed fund. It can also have an effect, as can capital gains that are realized within the managed fund structure. So, distributions coming out of an ETF, the rest being equal will be a bit cleaner and bit closer to the underlying yield of the investments as opposed to the managed fund structure.

I should just add too that another advantage of the ETF thing that you can get, when you're looking at the yield is the transparency. So, often you look at a lot of fixed interest managed funds and you wouldn't have the faintest idea what they're actually investing in, whereas now with the transparency of the ETF you can see exactly what the underlying constituents of this - of each ETF are. So whether it's Commonwealth government securities, New South Wales Treasury Corp issues, Commonwealth Bank paper, whatever it is, actually being able to understand who the issuers are in your ETF is much more transparent than in most managed funds.

St Anne: So, how do these fixed income ETFs differ from other income yielding investments?

Murphy: Yes. So, at the current time, the obviously topical one out there is term deposits, whose rates continue to be quite elevated. So, the running yields on a lot of these ETFs at the moment aren't particularly standout relative to term deposits. That's just a function of where the market is at the moment. So, looking in on a pure yield basis, not necessarily relatively attractive versus term deposits, but that won't always be the case and equally too, fixed interest does play a different role to what pure cash does in the sense of the duration exposure that you get and insurance of your portfolio, if you like, that that provides during bad times is necessarily a cash alternative deposit holding, who doesn't provides two different sort of things there.

St Anne: Finally, Tim, what type of investors will these ETFs appeal to?

Murphy: Sure, so like any fixed interest investment, it's going to appeal to those that are most conservatively-minded, have more of a focus on some regular income generation and a high degree of capital preservation.

So, that's really we've being waiting for in the ETF space today. You've only had these growth asset classes, so the likes of equity and property to choose from. But now as with fixed interest ETFs now live up and running on the ASX, those with the real conservative investment mindset have the option within the ETF space of choosing between a range of fixed interest and cash conservative options now.

St Anne: Tim, thanks for your insights today.

Murphy: Thanks, Christine.


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