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Best passive bond ETFs

Emma Rapaport  |  04 Aug 2021Text size  Decrease  Increase  |  
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Do you need bonds in your portfolio? The question is, of course, a personal one. Those with goals in the three- to 10-year range—say, buying a new home or retiring within the next decade—likely do. Bonds are also favoured by investors who may not be comfortable being 100% in equities, no matter their time horizons.

Exchange-traded funds focused on fixed-income securities can be excellent choices for getting exposure to bonds. ETFs are transparent—they track indexes with very specific duration and credit-quality traits—and offer few surprises. They're usually low-cost, which is even more important when investing in bonds than in equities: Every basis point paid in expenses is one less basis point in return, and returns are typically tougher to come by with bonds than with stocks.

Following on from our '3 equity ETFs to get you started' article, we survey bond ETFs which have picked up top-Morningstar analyst ratings. Funds that earn our highest rating—Gold—are those that we think are most likely to outperform over a full market cycle.

Australian bonds

iShares Core Composite Bond ETF (IAF) – Silver

  • Category: Australia Fund Bonds - Australia
  • Manager index: Bloomberg AusBond Composite 0+Y TR AUD
  • Fund size: $1.9 Bil
  • Management fee: 0.15%
  • Morningstar analyst rating: Silver
  • Primary investment: Investment grade fixed income securities issued by the Australian Commonwealth Government, Australian State-Governments, Supranational and Sovereign agencies and corporate debt issues.
  • Total Return 5-Yr Annualised: 3.2%

iShares Core Composite Bond ETF (ASX:IAF) stands out as one of the cheapest offerings among fixed-income passive funds. The rating reflects its low cost along with the strengths in scale and capability. Over the last few years, its allocation to government and semi-government bonds has become increasingly pronounced, with more than 80% exposure as at 28 February 2021. Almost in tandem, the portfolio’s duration has risen as the proportion of longer maturity government bonds has increased. The remainder of the portfolio mostly consists of corporate bonds and supranational securities. Thus, credit risk has remained fairly modest while interest-rate risk has crept up over time.

This strategy aims to fully replicate the Bloomberg AusBond Composite 0+ Index. The index composes of government and semigovernment bonds (82%), supranationals (8%), and corporate bonds (10%). The fund invests in high-quality bonds. AAA rated debt constitutes 65% of the benchmark's quality exposure. Banks and other financials issue most of the credit in the index. The fund's duration continues to increase with the benchmark as yields mostly hovered around historic lows barring the recent spike, up from 4.95 years at October 2016 to 5.8 years at 28 Feb 2021. The lengthening duration is a result of Commonwealth Government Bonds being issued at longer tenures, such as 30 years. But it means the fund faces the risk of rising yields globally, when we would expect active managers in this space to outperform their long-duration passive peers. Overall credit quality and appropriate diversification make this strategy an appropriate core exposure.

-- Zunjar Sanzgiri

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Vanguard Australian Fixed Interest ETF (VAF) – Silver

  • Category: Australia Fund Bonds - Australia
  • Manager index: Bloomberg AusBond Composite 0+Y TR AUD
  • Fund size: $1.4 Bil
  • Management fee: 0.25%
  • Morningstar analyst rating: Silver
  • Primary investment: Securities (bonds) issued by the Commonwealth Government of Australia, State Government authorities and treasury corporations, as well as investment-grade corporate issuers with a credit rating of BBB- or higher
  • Total Return 5-Yr Annualised: 3.21%

Vanguard Australian Fixed Interest ETF (ASX:VAF) is an excellent and inexpensive portfolio diversifier to cushion against large market drawdowns. This strategy aims to track the performance of Bloomberg AusBond Composite 0+ Yr Index, which is mainly represented by government and government-related issuance along with some investment-grade corporates. As of 31 May 2021, it is composed mainly of treasury (55.8%) and government-related (semi government and supranational) debt (36.7%). Corporate credit constitutes most of the remaining portion of the fund. The objective is achieved by employing an optimisation approach rather than fully replicating the benchmark. This entails selecting securities that emulate the index's key risk drivers including duration, sector exposures, and credit quality.

Vanguard’s government and quasi-government bonds allocation reached 92% as of April 2021, and duration has lengthened to 6.0 years. Its susceptibility to interest-rate risk has consequently risen while sensitivity to fluctuations in credit spreads remains modest. VAF is thus more likely to underperform active peers when interest rates rise or when credit markets perform strongly. Relatedly, astute active investors may have an edge over Vanguard in navigating shifts in the interest rate cycle. This was on display in February/March 2021 when yields spiked. Still, armed with a longer duration portfolio in a declining interest-rate environment, VAF’s long-term performance has been a tough hurdle for bonds -- Australia Morningstar Category peers to cross. A passive approach has been sensible in Australian bonds given many active strategies tend to take fairly modest bets against the index, leading to fairly narrow levels of return dispersion. Moreover, making the correct active duration call can be far easier said than done.

This effective and cheap diversifier is an ideal candidate for a defensive allocation.

-- Kongkon Gogoi

International bonds

Vanguard Intl Fxd Intr (Hdg) ETF (VIF) – Bronze

  • Category: Australia Fund Bonds - Global
  • Manager index: BBgBarc Glb Trsy Scaled Hdg AUD
  • Fund size: $ 608.0 Mil
  • Management fee: 0.2%
  • Morningstar analyst rating: Bronze
  • Primary investment: Index of securities (bonds) issued by the governments of countries that hold an investment grade credit rating.
  • Total Return 5-Yr Annualised: 2.36%

Vanguard International Fixed Interest ETF (ASX:VIF) is a noteworthy solution for investors seeking access to a portfolio of global government bonds at a lower cost. The strategy changed the index it tracks in April 2019 to the Bloomberg Barclays Global Treasury Scaled Index Hedged (AUD) owing to inclusion of Chinese government bonds in the Bloomberg Barclays Global Treasury Index. The main difference between the benchmarks is scaled exposure to Chinese bonds.

Vanguard applies a stratified sampling approach to match the interest-rate duration and credit quality of the index. Vanguard's process means it doesn't buy every security in the index, resulting in cost efficiencies and better liquidity while still capturing important benchmark attributes. The benchmark includes only government debt mostly issued by investment-grade countries.

Considering the chunky allocation to US (28%) and Europe ex UK (26%) debt, the credit quality of the instruments is high, with around 40% of the fund in AAA rated bonds (as at 31 May 2021). The interest-rate duration has been increasing over several years and sits at 8.4 years as at 31 May 2021 (up from 7.8 in December 2017). This lengthening interest-rate sensitivity leaves the strategy vulnerable to rising yields.

We believe active managers may be better positioned to navigate environments of increasing interest rates, rising inflation, or scenarios of economic or political instability. However, higher interest-rate duration at an index level can be beneficial, as experienced during the prolonged environment of falling rates around the globe.

Vanguard boasts notable trading and risk management infrastructure as well as a global, well-resourced human capital pool. Its global reach and significant scale allow this strategy to have the benefit of 24-hour trading coverage from three global investment centres. While a management fee of 20 basis points is slightly lower than the unlisted version of this product, the bid-ask spreads need to be considered. Overall, VIF is a great candidate for investors wanting cheap and simple exposure to global bonds.

-- Kongkon Gogoi

Click here to see the full list of Australian exchange-traded funds and here for Morningstar's coverage list.

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is the editorial manager for Morningstar Australia. Connect with Emma on Twitter @rap_reports. You can email Morningstar's editorial team editorialAU[at]morningstar[dot]com

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