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Bonds in vogue for income and defence

Arian Neiron  |  01 Apr 2019Text size  Decrease  Increase  |  
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More money is flowing into fixed-income ETFs as Australian investors seek defensive positions and brace for a slowing economy under a potential Labor government and its plans to axe cash refunds for franking credits.

Investors poured $136.4 million into Australian fixed-income exchange-traded products in February, accounting for 34 per cent of all ETP flows. Over the year to 28 February 2019, assets under management in fixed-income ETPs grew almost $2 billion or 54 per cent to $3.8 billion, reflecting more defensive portfolio positioning amid the stock market volatility. Flows to international fixed-income ETPs are rising too, up $24.4 million over February for a total of $530.1 million, which represents an increase of 29 per cent in the last 12 months.

On the other hand, Australian equity ETPs saw outflows of $49.8 million during February 2019, coming after December’s volatility and considerable underperformance compared to international shares. ETFs account for around 90 per cent of total ETP AUM. Fixed-income ETPs are largely made up of ETFs.

Corporate bonds in favour ahead of election

The increased flows to fixed-income ETFs come at a time when market interest rates are falling, pushing up the value of corporate bonds, which pay a higher rate of interest than government bonds. Investors are favouring corporate bonds as they see them as safer compared to equities.

Another factor at play is that investors are likely rebalancing their portfolios away from fully franked shares towards other income-producing assets ahead of a likely Labor party win at the coming federal election – which is tipped for 11 May.

The Labor Party has said it will wind back cash refunds for surplus franking credits from 1 July 2019. Removing the tax incentive on franking credits will encourage investors to rebalance their portfolios away from shares that pay fully franked dividends towards other income-producing assets such as Australian dollar denominated corporate bonds.

Individuals and funds currently receive a refund of franking credits if the franking credits they receive on dividends exceed their total tax payable. Those not paying tax, including retirees on a minimal tax rate and superannuation fund members in pension mode, would be the most disadvantaged by Labor’s policy.

With the likely outcome that franking is wound back, corporate bonds are now seen as an alternative income source. Dividend imputation has caused many investors to be heavily allocated to higher risk assets, such as the bank shares, and underweight fixed income assets such as corporate bonds.

Higher corporate bond yields draw investors

In the aftermath of the global financial crisis, when interest rates fell, investors have sought alternate sources of income, as traditional income sources such as term deposits no longer pay a decent income. The average interest rate on all bank term deposits was just 1.95 per cent in February 2019, down from 2.0 per cent a year earlier and less than half the 4.40 per cent they paid in February 2011, according to data from the Reserve Bank of Australia.

An alternative, or complement, for higher-risk income-producing assets are Australian-dollar denominated corporate bonds. Investing in a well-constructed portfolio of corporate bonds has the potential to provide a diversified credit exposure across many sectors while still maintaining a yield premium for the defensive allocation of an investor’s portfolio.

Corporate bonds are relatively defensive investments, which means they may do well when the economy slows down, which is expected for Australia in 2019.

ETFs: opening up investment options

While the corporate bond market was previously difficult to access, ETFs have opened up the market to all types of investors. In recent times, several new fixed-income ETFs have been launched, allowing investors quick access to both government and corporate bonds.

Because ETFs are traded on the ASX, investors can easily buy and sell in amounts that suit their individual investment needs. ETFs that track a well-diversified bond index offer instant diversification in a single trade. Compared to unlisted managed funds, ETFs also provide more transparency in terms of their holdings and are generally more liquid and lower cost.

However, to understand the quality of a corporate bond ETF, it is key that investors look under the bonnet of the fund to understand the index and further still the investment strategy that the ETF manager is using to track the index.

Key things to look for are the credit quality of bonds in the index and the diversification of issuers by both number and across market sectors.

The quality of a bond is determined by its credit rating. A bond and its issuer usually carry a credit rating determined by independent ratings agencies, which give an indication of how risky the issuer and therefore its bonds are. This is an assessment of the risk that the issuer will not be able to pay coupons or the principal when they are due. If a bond has a high credit rating within a band called “investment grade”, it is considered to be safer than “non-investment” grade bonds.

Sub-investment grade bonds are considered to be more risky. The yields on low-rated bonds are therefore higher than the yields on safer, higher rated bonds.

Other things for investors to consider are the type of bonds in which an ETF invests. Bond indices may include a variety of bonds such as government bonds, semi-government bonds, corporate bonds, floating rate bonds, inflation-linked bonds or offshore bonds, or a combination of these. A range of fixed income ETFs are available to investors on ASX.

is the managing director of VanEck Australia.

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